title: Addressing the challenges of digital lending for credit markets and the financial system in low- and middle-income countries
Creators: name: Sommer, Christoph
Publisher: name: German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
publisherIdentifier: https://ror.org/01t3zke88
publisherIdentifierScheme: ROR
Year: 2021
Subjects: subject: Social finance
subject: sustainable finance
subject: social investment
subject: EU taxonomy
subject: definition
subject: standard
subject: social bond
subject: sustainable equity
subject: sustainability rating
subject: development policy

description: The demand for digital financial services has risen significantly over recent years. The
 COVID-19 pandemic has accelerated this trend and since the focus has shifted towards
 economic recovery, digital lending has become central. Digital credit products exploit
 traditional and alternative financial and non-financial data to provide access to finance
 for households and micro, small and medium enterprises (MSMEs). While it makes lending
 more inclusive for underserved or unserved households and firms, its increasing influence
 also brings forth challenges that need to be addressed by policy-makers and regulators in
 order to guarantee well-functioning credit markets and broader financial systems that
 foster sustainable economic development. <br> A central concern is the adverse effect of
 digital lending on the stability and integrity of credit markets (and potentially the
 wider financial systems). The rise in non-performing loans, even before the COVID-19
 crisis, has been associated with an increase in digital credits. New players with little
 experience enter the market and exploit regulatory arbitrage, but often these players have
 no (or only a partial) obligation to report to respective systems for sharing credit
 information or to supervisory bodies, which introduces severe vulnerabilities. <br> In
 addition, the low entry threshold of digital financial products, due to their convenience
 and simplicity for customers, provides fertile ground for exploitative financialisation.
 Underserved households and MSMEs with limited financial literacy may be lured into taking
 up unsuitable and unaffordable digital credits, leading to over-indebtedness and
 bankruptcy. <br> The last challenge arises from significantly shorter loan maturities in
 MSME lending if current forms of digital lending are scaled up. This is problematic, as
 firms need loans with longer maturities to realise productivity-enhancing medium- and
 long-term investments, many of which include complementary investments in labour, thereby
 contributing to an improvement in job quality. <br> Governments and regulators need to
 strike a balance between leveraging the potential of digital lending for inclusive finance
 and economic recovery from the COVID-19 crisis, and mitigating associated risks. In
 particular, they should, together with providers of technical and financial development
 cooperation, consider the following: <br> - Fostering the integrity of (digital) credit
 markets. Regulators should establish specific licenses and regulations for all digital
 financial service providers, and introduce obligatory reporting requirements to
 supervisory bodies and national systems for sharing credit information. <br> - Preventing
 exploitative financialisation. Regulators need to require digital lenders to present the
 costs and risks of their loan products in a manner comprehensible to consumers with little
 financial literacy, and extend consumer protection policies to digital financial services.
 <br> - Ensuring availability of loans with longer maturities. Development finance
 institutions and other national and international promoters of (M)SMEs should assist local
 banks in the provision of longer-term loans, e.g. by offering respective funds or partial
 credit guarantees. <br> - Establishing regulatory sandboxes. Regulators should launch
 regulatory sandboxes to test legislation in a closed setting and to learn about risks
 without hindering innovation.
description: Briefing Paper, 23/2021