Regulating Digital Financial Services to Promote Financial Inclusion

Financial services delivered over mobile phones are key to improving financial inclusion in developing countries, especially of the poor living outside major cities. The bottom line is that very few banks anywhere are genuinely interested in the poor, and the absence of physical banking infrastructure in remote parts of developing countries is a major obstacle to the provision of banking services.

However, another industry sector knows how to profit from serving the poor, as it does so already, and that is telcos providing mobile phone services. Their business model is sufficiently low-cost to be viable and in many countries, their customer base is already massive. Today, globally, over 1 billion people have a mobile phone but no bank account. Telco-provided mobile financial services (MFS) offer these people ways to save, make payments quickly and conveniently, and often, acquire insurance and credit.

The story of Vodafone in Kenya, with M-Pesa, is well known. Today, 10 years after its inception, M-Pesa provides a broad range of financial services to a sizable proportion of the population who otherwise would not enjoy them. Many countries have tried to emulate this success, but few have succeeded. The obstacles have been many, including the understandable preference of major providers to roll out identical products across very dissimilar markets. One obstacle has been regulation.

In nearly all countries, the regulation of MFS falls to the local central bank and just as if you take a health issue to a surgeon you are likely to receive an operation, if you take an issue to a central bank, you are likely to receive a regulation – and not just any regulation but one crafted by someone skilled at dealing with serious risks to the safety and soundness of the national financial system. Yet, these are precisely the sorts of risks that MFS virtually never pose.

So, the overly stringent regulation of these nascent financial services has been a real problem in many countries. The example of Kenya is instructive, as the Central Bank of Kenya largely left the provision of MFS alone until these services began to become systemically significant.

The first obligation of developing country central banks, and indeed of all central banks, is to stay atop developments in their market – supported, where necessary, by appropriate regulations that require periodic activity reporting to the central bank.

The developing country's central bank that wants to regulate this area needs to think carefully. Less is more, most often, when it comes to MFS. The DFS Research Team at UNSW Sydney has produced a Regulatory Handbook to assist developing country regulators with this essential thinking, and a Regulatory Diagnostic Toolkit to assist central banks in identifying barriers and gaps in their regulatory regime.

Typically, there are only three areas that initially call for regulation: protection of the funds and of consumers, as these are essential to the viability of the ecosystem, and AML/CTF regulation, as this is mandated by international regulations.

The traditional way to protect the funds is to require the provider to keep an amount equal to the amount of issued e-money on trust in an account with a commercial bank, and we have analyzed how best to do this. In civil law systems which lack the legal institution of a trust, the task is more complex but the risk is resolved in analogous ways, as we have analyzed here.

The protection of consumers should enhance trust in the system but needs to be kept simple, and provide effective redress mechanisms. All the rules in the world are useless if a consumer who has lost their money cannot make a free call to a number that is answered reasonably promptly by someone who can fix the problem. Central banks need to focus as much on the redress mechanism’s effectiveness by – among other things pretending to be distressed customers – following a set of rules; as we have suggested here.

The other step that can serve to protect consumers is a simple provision that makes telcos liable for their agents’ actions. The money-in/money-out functions for e-money are typically provided by the same local storekeepers who sell airtime for the telcos. Some telcos insist that these agents are independent contractors and that the customer’s recourse ends with the agent – at least formally. This undesirable and misleading allocation of responsibility should be prohibited, as we have explained here.

In poor countries, AML/CTF regulations often cause more problems than they address, especially by dissuading banks from providing the accounts that low-cost money transfer operators need to provide affordable remittance services. The behavior of banks in closing these accounts is termed ‘de-risking,’ but while it lowers banks’ risks, it actually raises system-wide risks as it forces these essential remittances into informal, untraceable channels. We have analyzed how local regulators need more support in implementing proportional, risk-based, AML/CTF rules.

Apart from light-touch regulations to protect the funds and consumers, and prevent money laundering and terrorist financing, our advice to regulators is to maintain a watching brief over the sector but otherwise, leave it alone – let it flourish. Nurture it with the benign gaze and moral support of the central bank without burdening it with regulations suited to a bank that can generate serious risks. This support should include the central bank encouraging providers to develop products suited to that particular market. Both telco product development teams and central bankers need to get out of the capital city and spend time in the villages talking to customer focus groups; for it is from meeting customer needs, understanding the customer journey, and providing an enabling, light-touch and nuanced regulatory regime that a flourishing mobile financial ecosystem will be encouraged to grow to the benefit of the poor, especially those living outside the major cities.