Character, not collateral
Character-based credit profiling is a potential multi-million dollar industry. This article explains why tapping into this market is potential opportunity for Somali financial services companies
The Loan-to-Deposit Ratio (LDR) is an indicator of a bank’s liquidity, its ability to retain customers or deploy funding effectively and profitably. It is a simple ratio which is calculated by dividing the net customer loans (held at amortised cost) by the total customer deposits. A ratio of greater than 100% indicates that a bank has loaned out more than it has received in funding – an indicator of a potential liquidity problem. Conversely, a ratio that is well below 100% shows a bank is not adequately growing its business activities with the funding it has, thereby failing to generate profits and good value for shareholders. An LDR of between 80% - 90% is considered to be a fairly adequate threshold.
While so, when one looks at the aggregate LDR of Somali banks, as published in the June 2021 "World Bank Somalia Economic Update", it is just over 33%. The cash in hand, as a percentage of total assets, is over 35%. This means a large proportion of funding received by Somali banks, in the form of deposits, are not put to good use. Look closer at the asset side of the banks’ balance sheets and the biggest proportion relate to equity holdings, real estate investments and financing assets. These three asset classes are all either investments holdings or indeed collateralised portfolios.
"More importantly, what is happening with Somali banks is that they are not channelling the deposit funding they receive into the businesses that need funding to grow and create jobs in the economy. By choosing to pass on opportunities to lend to people and businesses that may not have required collateral, banks will be faced with the twin problem of low profitability and increased credit losses from overreliance on riskier investments, eroding their capital over time."
All banks need to finance their businesses activities and the way they choose to do it has significant implications for a country’s economy. This is because bank funding is a key pillar for economic growth. More importantly, what is happening with Somali banks is that they are not channelling the deposit funding they receive into the businesses that need funding to grow and create jobs in the economy. Equally, by choosing to pass on opportunities to lend to people and businesses that may not have the required collateral, banks will be faced with the twin problem of low profitability and increased credit losses from overreliance on riskier investments, eroding their capital over time.
A sustained reduction in bank profitability will also eventually eat into banks’ capital and ultimately threaten their solvency. The banks’ current collateral-based business approach, although intended as a prudent way of managing risk, therefore indirectly incentivises low-growth and excessive risk taking. This is why the banks’ preference to hold equities and invest in real estate, rather than spreading risks through asset holding comprised of lending to people and businesses, means their risk profile is in fact much more elevated than reduced.
Banks assume they need to use the collateral-based business model out of risk management necessity. In other words, the lack of credit market opportunities, and enforceable rules to deal with delinquent debtors, mean all they can do is to lend against collateral. However, pricing the value of collateral in not easy in a country with no established market. Moreover, by opting for this approach, banks are overlooking the vast opportunity of tapping into the underserved, but highly profitable, groups - the less risky unsecured lending to people and businesses.
The competition from mobile money operators
Somali banks also operate in a market that is becoming fairly competitive. Mobile Money Operators (MMO) continue to provide basic mobile banking service on a much wider scale, leading to a wider disaggregation of the sort of services banks would have liked to offer. In particular, it means MMOs are now better placed to go beyond the current payments model into wider lending and banking solutions. If MMOs, which now have more active user accounts than the whole population, were to take this leap, a real transformation in banking services would follow, eating into the banks’ market share and diluting their profitability even further. If banks fail to respond to the changing nature of customers as a result of new technologies and their evolving needs, they would lose opportunities for potential growth.
This does not mean MMOs can become quasi-banks overnight. Regulatory requirements besides, MMOs are forced to contend with their own business model challenges. Customers who use mobile money services typically do not have access to savings and spend most of what they receive almost instantaneously. As a consequence, banks with access to savings would have the ability to lend, but cannot do so because of their collateral-based business model. While MMO cannot lend money because of the transaction nature of their clients’ funds, but can use their customer’s character to build credit profile which has a material monetisation potential.
This mismatch in scale and monetizable potential is what this article intends to highlight. In particular, how the transformative potential of harnessing the character profile of MMO customers can be used to replace the collateral-based business model which is impeding the growth potential of Somali financial services.
Character-based business model
MMOs enjoy a significant market advantage and have a potentially monetizable opportunity in character-based customer profiling. They can track exactly how much money their users spend in any given day, the inflow and outflow average of each user; when, where and how their users use their funds. These insights alone could be used to build a character-based credit potential which is much more accurate than a traditional credit-scoring model.
A character-based business model has three key advantages:
(i) It allows banks and MMOs to build relevant products for their customers based on their profile, thereby building much more enduring business relationships.
(ii) It allows financial services firms to tailor their product proposition to meet the changing nature of their clients’ business and personal needs. For instance, an MMO user who receives and makes large value payments could be easily transitioned to a banking relation-ship and offered more products and services.
(iii) By harnessing the insights gained from character-profiling, which is a much more accurate predictor of credit potential, financial service firms can increase their technological innovation with the ability to identify and offer ancillary services (eg. investments, insurance, healthcare).
Monetisable Potential
Building character-based business model simply means using technology and insights from client behaviours to deliver both enhanced customer experience and business profitability. It starts with harnessing the existing knowledge MMOs have and partnering with banks to create a potential growth market for the banks’ unused funding. This business model is only viable if there is appropriate governance and risk management framework as well as a partnership approach with other banks.
There is a clear advantage for incumbent MMOs that have a significant market share. However, MMOs cannot be profitable unless they get into the lending business – which is the preserve of regulated institutions with a large sticky deposit base. By the same token, it would not feasible for existing banks, or indeed new operators, to spend hugely on efforts to poach incumbent MMO customers with free offers. For such strategy to be successful, new competitors need to be able to provide the same services MMOs provide with lower cost, or better service at same cost – options which are both costly in the long term with no certainty of success. This is why a partnership approach is likely to be a win-win for both banks and MMOs.
Character-based business profiling is a business opportunity on its own and needs to be managed as a separate entity with its own governance and risk management framework. This is particularly important because extracting the potential transformative value this business can deliver will require clear decision-making and the ability to provide more personalised experience for customers, as well as the development of products that can be marketed widely to different market participants.
There are a number of different permutations of how this character model could be made to work. A simple model based on the three client characteristics below seems adequate. These are payment profile, product/service profile and geographic location. Each attribute provides a specific insight of client behaviour and all three combined can provide a fairly stable and predicable insight of customer character. This information will be of benefit to a wide-range of customers, including clients, banks and non-bank financial firms.
Market attractiveness, competitive position and feedback loop
There is a difference between the potential market attractiveness of this product and the competitive position of the MMO that are currently well-positioned to develop this product. The market potential for this product is attractive with strong potential for growth. Given the bank’s lower LDR, this is a product that will be of great value to financial institutions and support significant unsecured lending growth. However, this does not mean the MMOs are necessarily best placed to develop it on their own. In order for this product to be successful, there must be wider market and user confidence, collaborative joint-venture with the financial services industry, and transparent character-based methodology which is acceptable to wide-range of market participants. These non-price factors will be critical to the success of both the development and wider acceptance of this product.
A character-based profile is merely a starting point and would quickly become out of date if there is no feedback loop from users – information that would be critical to inform the on-going credit profile of customers. For instance, Bank A might initially onboard and extend credit to a customer based on the existing MMO character profile. However, as the user builds more transaction history in their bank’s credit profile, this information needs to be reflected in the initial character-rating. This is why an a joint-venture approach that has wider industry input is likely to be a much more successful and enduring product than one developed by one firm. Creating this feedback loop would require industry participation and input into a system with a shared governance framework.
The current collateral-based system that Somali banks use will act as a constraining factor for the reasons outlined in this article. By focusing their service offering to clients that can post appropriate collateral (whose risks will be difficult to price appropriately), or taking equities in businesses (with the added agency costs,) banks are unlikely to take advantage of the sort of growth opportunities they need to thrive by extending services to the vast majority of the unbanked. It is equally important to note that, in the age of low-value, high volume mobile money, it would not be feasible to set up a new standalone credit profiling infrastructure especially if the vast majority of the unbanked are content with using their mobile money service.
As such, for character-profiling to work best, both banks and MMOs would be much better off with a coopetition strategy. The potential financial returns from developing a well-thought through character profiling industry-standard system will indeed be considerable.
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The personal views, thoughts and opinions expressed in the text belong sorely to the author, and not necessarily to the author’s employer, organisation or other group or individual.
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