This short post gives an overview on how blockchains could impact financial inclusion and “banking the unbanked”. There are two parts to this:
- Financial inclusion: who counts as unbanked? (it’s not just poor people)
- How might distributed ledger (“blockchain”) technology help?
Financial inclusion: who is unbanked?
Poor people. Yes, poor people are financially excluded from the formal financial system, and may not be able to participate in digital finance in the same way others do. They may not be able to get well priced loans, or they may not even be able to open current accounts.
But they’re not the only unbanked segment.
SMEs. Small and Medium sized Enterprises (SMEs) are often financially excluded – this varies by country but is not just in the developing world. In rich countries, companies can be excluded from the formal banking infrastructure based on their industry or ownership structure.
How are SMEs financially excluded? At worst, they may be legal businesses but not have access to even a basic bank account, eg Bitcoin exchanges or those companies in industries that are legal but morally polarising eg marijuana, gambling, and adult.
Matt Levine’s commentary about American banks refusing to bank banks who bank bitcoin exchanges is worth a read in full – here’s my favourite bit:
The concern here is that JPMorgan might transfer money for another bank, and that other bank might transfer money for a bitcoin exchange, and that bitcoin exchange might transfer money for a drug dealer. Which, in the eyes of the law, means that JPMorgan might as well be dealing drugs itself.
I sometimes think about the analogy between banks and airlines: If a drug dealer uses a bank to move money, that bank is held responsible, but if he just gets on a plane with a bag of money, no one thinks to hold the airline responsible.
But this is much further removed. This is like, a taxi driver flies on United Airlines from New York to Miami, and in Miami he picks up a guy who owns a boat and drives him to the marina, and then the guy with with boat transports bags of cash for a drug dealer, and you hold United responsible.
Vast swathes of legitimate financial transactions will be cut off if you punish banks for dealing with people who deal with people who deal with people who commit crimes.
Even those in traditional industries can struggle to get loans, especially new companies that need loans more than most, or those in non-traditional lines of business (eg in new industries without well understood models or metrics).
Basic current accounts are crucial to any business, and loans are the lifeblood of SMEs, essential for working capital (buying raw materials in order to make products) and expansion (buying more operating equipment, opening new offices, factories, or lines of business).
But it’s not just people and companies who can be financially excluded.
Banks. Perhaps surprisingly, banks are also increasingly financially excluded, especially those in poor countries.
You might imagine a community bank in Papua New Guinea whose clients are plantation owners wanting to export their goods, and receive USD in return. To send and receive USD electronically, the community bank would need to be part of the USD network. (If the payments were made purely in physical banknotes, then banking is straightforward, using the bank’s vault or locked boxes. But digital payments work differently.)
Side note: You may ask why couldn’t everything be done in kina (the currency of Papua New Guinea)? Perhaps the foreign companies don’t hold kina and the FX charges to convert USD to kina are prohibitively expensive. Perhaps the exporters find USD more useful – maybe they need it to buy agriculture machinery from abroad. Perhaps the relative stability of USD compared with local currencies is attractive.
So how do digital payments work? Typically the community bank would need to open a USD account with one of the larger American banks, preferably in the USA, and use that account to keep their digital USD. This is known as their ‘nostro’ or ‘correspondent bank account’, and the American bank is called their ‘correspondent bank’.
However these smaller banks are increasingly having their accounts closed down – a process the larger banks call de-risking.
Why are they unbanked?
Cost and risk.
Any bank providing a bank account, whether it is for a poor person, an SME, or another bank, makes two calculations to determine if the customer should be banked:
- Cost: Will my revenues cover my costs?
- Risk: How risky is the customer, and what damage could they do to me, financially, and to my reputation?
Unbanked poor people
This is mainly about the bank’s costs, rather than the revenue or risks. The costs lie primarily in onboarding: the processes around understanding who the customer is, where they live, how they make their money, and if they are on any naughty lists. The cost in onboarding a customer and maintaining the account needs to be less than the revenues from that customer, and if the customer doesn’t do very much activity, the account is unprofitable for the bank.
Companies are more complex than people, and so, performing a due diligence on a company is a lot more time consuming and expensive. There are potentially many legal entities associated with the company. There are also owners and directors to background check. There are lots of documents, and they need to be manually understood by humans. This process is called Know Your Customer (KYC) and causes banker officers to roll their eyes.
A bank officer must understand what the company is, what it does, what its operations are, who owns it, and how it makes money. As a company evolves, a bank officer needs to stay on top of this in case the company does anything that might put the bank at risk of reputational or financial damage. And that’s just for a current account.
On top of this, for the bank to issue a loan to the company, the bank needs to understand the risks it is taking, and how likely the bank is to get its capital plus interest back. This means understanding the business models and risks of the company. The interest from the loan needs to compensate the bank for this effort and for the risks the bank is taking. As a result, many good companies are priced out of getting a loan.
Unbanked other banks
The reason given for closing the bank accounts of other banks is that the revenues from opening and keeping these accounts open do not cover the increased costs of compliance with know your customer (KYC) and anti money laundering (AML) rules. Furthermore, there is reputational and financial risk to the big bank providing the account to the smaller bank: if the smaller bank is found to be money laundering for its customers, or becomes embroiled with political scandal, the big bank can get fined.
The Economist wrote an excellent article about correspondent bank de-risking, summarising that “Charities and poor migrants are among the hardest hit”.
So, how might distributed ledger technology (DLT) help?
For individuals and small businesses, there are currently many initiatives around digitising and streamlining onboarding and KYC processes, both within individual banks and industry-wide. Self sovereign identity using DLT could make the data capture part of KYC cheaper and easier. Of course, the other piece of the cost is banks streamlining their own internal systems. KYC is an internal process after all. Banks have never really been under pressure to reduces operational costs in quite the same way they are being squeezed now, so we will see if and how banks can make their internal operations more efficient. There might be a role for internal blockchains, especially if a bank is fragmented (most of them are), and departments don’t want to rely on each other or trust each other, or want to be able to prove authenticity of data to a regulator.
Could DLT increase bank revenues from SMEs? There are some interesting ideas around SMEs using DLT for provable transparency about their supply chain and financial incomings and outgoings. This could enable banks to provide cheaper working capital (short term loans), as banks will have better insight into the risks they are taking with the SME, and better insight into the SME’s ability to pay back the short term loan.
How might this work? Let’s say a bank’s client wants a loan, and the bank wants some comfort that the business is healthy and the loan will be repaid. If the client is part of a supply chain of widgets, and the records of the widgets, logistics, invoices, and associated payments are recorded on a distributed ledger, then some of that data can be selectively shared to a bank to prove the status of activities. Data that has been attested using digital signatures, with hashed chains of transactions or provenance, is much more compelling evidence than “The cheque’s in the post”, or sending an excel file which can easily be manipulated.
By understanding SMEs better, banks can price risk more accurately and therefore can offer loans at more attractive rates, or offer loans where previously they would not have done so at all.
Of course, it’s not just DLT, it’s digitisation, APIs and straight through processing – but the digital signatures and chains of hashed data used in DLT can provide some guarantees that existing frameworks don’t currently use.
Finally – new business models
This is the hardest to predict. How might industries evolve when some of the roles of traditional third parties are replaced by technology? What will be the new business models? Bitcoin and digital currencies are maturing to the extent that banks are being approached to custody these coins (or rather, the private keys). Some people even want their ICO tokens kept safe. Digital lock boxes will become more popular. What about other digital assets such as tokenised game objects? Proud owners of unique digital assets will want a 3rd party signatory, to make make it harder for them to be stolen.
In most DLT networks there is a role for “Oracles” – data providers that are used in automated business-to-business workflows (so called Smart Contracts). In some DLT networks, “Orderers” or “Notary services” will be adding a valuable service that can be monetised. Could banks play these roles too? Perhaps, but it is unclear whether revenue opportunities would directly lead to the unbanked becoming bankable.
This article was about the unbanked. It’s not just poor people who are unbanked, it’s businesses and other banks too. How might DLT help? The same way any technology helps: by reducing costs and increasing revenues so that previously unprofitable customers become profitable. Two relevant features of DLT are:
- DLT acting as a selectively accessible repository of authenticated documentation and evidence
- DLT creating a new business to business protocol that is efficient, auditable, and can be used for information and digital asset transfer and management.