The Basel Committee on Banking Supervision has requested comment on a draft guidance document that for the first time addresses the responsibilities of regulators and supervisors in the context of financial inclusion. Given the potential impact of this guidance on regulators around the world, we invited Daniel M. Schydlowsky to review and comment. Dr. Schydlowsky is a fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School, and the former head of the Superintendency of Banks and Insurance Companies of Peru.

The draft guidance issued by the Basel Committee is unquestionably an enormous step forward. It identifies, describes, and qualifies how supervisors should behave in relation to financial inclusion. It also describes numerous particular situations that supervisors have to confront and suggests responses. It thereby provides the representative supervisor with what amounts to an encyclopedia of supervisory wisdom.

The guidance is comprehensive, it treats (almost) everything. That is its strength. But, it did not create an effective hierarchy of importance to guide supervisors as they confront their new mandate to generate financial inclusion. In what follows, some central issues are raised, which, in the opinion of this author, need to be incorporated into the guidance or highlighted to denote greater relative importance.

The Dilemma of the Supervisors

  • Too much to do with too few resources: The supervisors have limited staff and many things to do, starting with making sure the financial system is safe, the books are kept properly, required information is supplied reliably and on time, and capital and other requirements are complied with. On top of this come new responsibilities related to financial inclusion. When reading the guidance, a whole second staff would appear to be needed to comply properly with what is suggested. It is absolutely imperative that the limited resources of the supervisor be factored into what is requested that they do.

  • Much worse in small countries: The situation is even more critical in small countries. Where there is a small population, the pool of talent and of trained individuals is unavoidably small as well. Yet the requirement for supervision does not shrink proportionately. Small countries are therefore particularly disadvantaged in all matters of regulation.
  • Now add the load of innovation and digital finance: Consider now that financial inclusion requires mastering a range of new skills, introducing a number of new regulations and monitoring a range of new phenomena. With the introduction of digital finance, the requirement becomes greater still. Not only is the medium new, the issues involved are novel and the solutions are often far from past practice. It is important, therefore, that the guidance pay the necessary heed to the operating limitations that regulators face as they confront the challenge of moving forward.

The Dilemma of the Supervisees

  • Too many rules to comply with: Excessive regulation is something financial institutions regularly complain about, especially when there are several independent regulators who have overlapping responsibilities. A major example is usually consumer protection. Many of the rules are unavoidable. However, there is far too little awareness on the part of regulators of the need to update, prune, and otherwise make regulations less burdensome.
  • Absorbs a major fraction of their operating capacity: An important fraction of the institutions active in financial inclusion tend to be the smaller members of the financial system. They therefore have less staff and less well-paid staff. Accordingly, a larger proportion of their operating capacity is absorbed in regulatory compliance. That leaves less capacity available to fulfill their primary objective, and raises costs. Where digital finance is concerned, the large financial institutions tend to be on the forefront, but the small ones are again disadvantaged because the learning burden on them is greater. Accordingly, again, they are less able to fulfill their inclusionary function. Proportionality in supervision is intended to compensate, however, much remains to be done to make it really effective. It is important, therefore, that the guidance take full cognisance of this.

The Solution: Offsite Supervision with Statistical Analysis

  • Offsite supervision with capacity for statistical analysis: Traditional bank supervision is highly labor intensive and operates bank by bank. The advent of computers and internet links has facilitated the introduction of off-site supervision. However, statistical analysis such as search for outliers, identification of non-standard cases, or application of star and significance tests is still far from standard procedure. Nor is it common to scan across data from different institutions in order to identify oddities. Yet such techniques offer substantial economies of effort and should free bank inspectors to concentrate on the tasks for which informed judgement is irreplaceable.
  • Apprenticing high quality inspectors for judgment: If “routine” inspection is turned over to off-site and statistical teams, this would allow on-site inspectors to be upgraded and trained for the application of high quality informed judgment. Such a transformation of inspectors can only be accomplished with an apprenticeship program, for judgment can only be learned through imitation and through observing a master at his/her task.
  • Improving quality mix of management of supervisees: The counterpart of the change towards off-site supervision on the part of the supervisors is change by supervisees. These institutions must also be upgraded, to be able to understand and handle the new statistical tools and respond appropriately to the more analytical approach of the on-site inspection visits. Along the way, there will no doubt be productivity increases in various units of the financial system, especially the smaller and less well-staffed ones.

Requirements of the Digital Finance Revolution

The essence of revolution is change, change writ large. The digital finance revolution is no different. Here are some highlights that the guidance might bring out more forcefully:

  • Know-Your-Customer: When somebody creates a bank account on his/her cellphone, a problem immediately appears as to how to ascertain their identity. When a country has a national identity card, this problem becomes easier to solve. Moreover, without a personal presence, questions arise about the security of electronic payments. How can the receiver be sure who the money is from? How can the payer be sure it has gone to the proper destination? These problems have by now been solved, and solved in more than one way. What most of these solutions have in common is that they require low identification for small transactions and increasing identification as transactions become larger or more frequent. In this way, risk is reflected in the identification requirement. This constitutes proper application of proportional regulation.
  • De-Risking: International banks have recently been fined very substantial amounts for lapses in care in the area of money laundering. They have responded by substantially reducing their willingness to do business with major categories of clients: correspondent banks in small jurisdictions, money remittance companies, and even officials of non-U.S. governments. Their purpose has been to avoid additional fines. Yet such de-connecting substantially harms the international payments system and does little to actually guard against money laundering. It must be clearly understood that smurfing, the laundering of small amounts of money, is easily detectable by simple computer routines, and is also highly inefficient as a way to launder significant amounts of money. The large money launderers are much more sophisticated and disguise their transactions as routine trade or finance. Thus de-risking, as currently practiced, does not accomplish its purpose and does needless damage to the international payments system and the goals of financial inclusion.
  • Paths to interoperability and interconnectivity: For digital finance to realize its potential, its platform needs to be interoperable and interconnected, i.e., any cellphone should be able to remit to any other cellphone, regardless of what telco it is connected to, and, any account in any financial institution should be able to remit to any other account in any other financial institution. Typically, telcos give preference to their own and financial institutions do the same. Therefore, achieving a situation where all are seamlessly interconnected requires substantial institutional rearrangement and innovation. Moreover, since there are many starting points for this process, there are also many routes to getting there, some more efficient or effective than others. This path dependence is still not well understood but certainly deserves mention in the guidance.
  • Costs and economies of scale – international cooperation? Digital finance is an activity with large economies of scale. So large, indeed, that they will exceed the economic dimension of some countries. The question then arises whether it would not be advantageous for smaller countries to join together to mount a single platform. If so, then a number of new and interesting regulatory and supervision issues arise, none of which are touched on in the guidance.

Challenge: Bringing Down the Cost of Inclusive Finance

Inclusion is often treated as a matter of access and usage, but rarely as a matter of cost and price. Yet expensive access is really tantamount to little or no access. The challenge is to reduce the cost of the institutions that provide financial inclusion, so that they can, in turn, pass these savings to their clients. In turn, the guidance might suggest regulatory facilitation of such procedures.

  • Industry-wide procurement: It is well known that purchasing in large quantities provides cost savings. If the institutions dedicated to financial inclusion developed joint procurement they would in all likelihood realize substantial savings.
  • Outsourcing for economies of scale: Data processing, for instance, is an activity subject to economies of scale. Accounting is basically data processing. Accordingly, outsourcing to third parties should provide considerable cost savings. For sure, the requisite safeguards would be required, with regulatory approval – from Chinese Walls to avoid co-mingling of data from different institutions, through assurance of confidentiality, through back-up arrangements for operational risk. Precedents from multinational banks that pool the data processing of their various subsidiaries into a few locations are a clear indication that such cost savings are available.
  • Psychometrics and big data for risk assessment: Risk in lending is a major consideration. It drives origination cost via the need for costly gathering of information on potential borrowers. It also drives the interest charged which must cover losses in addition to operating costs. Psychometric testing has proven its worth in personnel recruitment; it is now being applied to lending decisions. Big data provides another avenue to determine individual behavior as concerns integrity and reliability. Early results are promising and may enable a much finer classification of borrower risk and therefore the potential for better risk targeting and pricing. Accordingly, for a large number of borrowers a lower rate would result. In turn, with lower financial costs, their business results would be more robust, thereby initiating a virtuous cycle of increased capital accumulation.

The Guidance Needs a Greater and Clearer ‘Dynamic Dimension’

Supervisors should keep the financial system safe. This is clearly the first obligation of the supervisor. However, this obligation must be understood to be dynamic. An ossified financial system is not a safe system. It must be flexible and it must evolve with the needs of the society that it serves.

  • Therefore, the supervisor should help the financial system modernize, become more inclusive and serve the public better. Thereby, the financial system will maintain legitimacy, as it is increasingly seen to provide a needed service. However, this implies at least some level of consumer protection, introduction of new services and products and, above all, a pricing structure that is not perceived to be abusive and an attitude that is seen as consumer friendly.
  • The supervisor should also do whatever is needed to bring about digital finance as soon as possible. The benefits will be extensive and progressively distributed.

Cellphone banking represents the greatest revolution in payments systems since the invention of paper money. Because it is not stymied by physical obstacles, it will penetrate the backwoods. Accordingly, it will benefit the poor and the distant and partly offset their disadvantages. Accelerating the introduction of digital finance and ensuring that the system is interoperable and interconnected constitutes the greatest contribution to economic welfare, and especially to the disadvantaged, that any supervisor can make.

The guidance would become even more helpful if these considerations were incorporated in the revised version.

To hear our webinar discussion of the guidance, featuring Dr. Schydlowsky, Dr. Njuguna Ndung’u, the former Governor of the Central Bank of Kenya, and Juan Carlos Izaguirre, a CGAP representative member of the drafting team for the Basel Committee, click here.

Image credit: Accion

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