Good Customer Service versus Bad Regulation
Learning from Gandhi:
addressing the current
dilemmas in microfinance
Hinduism and Microfinance
The Financial Crisis
A Sketch of a Credible Explanation
Money Market Funds, Bank Runs and the First-Mover Advantage
The Morality of Money Lending
The Case for Central Bank Liquidity Facilities for Institutional Money Market Funds in the Offshore Market
Creating Sustainable Micro-lending in London
Darwin and Philosophy
David Hume's "Of Suicide"
Is God a democrat?
The Risk Premium
According to a recent research report from New Philanthropy Capital,
Financial exclusion describes the situation of people who cannot or do not access and use appropriate financial products and services.1
The term "financial exclusion" is used here to describe two groups of people: those who choose to avoid the mainstream financial service providers; and those whom the mainstream providers choose to avoid.2
Much public policy discussion around financial exclusion ignores the distinction between voluntary and involuntary exclusion. Presumably because public policy makers are simply interested in increasing inclusion rather than the more complex issue of expanding choice.
It is widely assumed that financial exclusion is due to some feature or characteristic of those who are excluded: they live in a poor neighbourhood; they don't have a credit history; they can't manage their own money; they don't understand financial products; they have low income so they are high risk.3 This is all nonsense.
All over the world - including here in London - micro-lenders have demonstrated repeatedly that poor people are bankable. They do not suffer from worse financial capability than other groups.4 Rather lack of resources makes poor financial capability, where it occurs, a bigger problem.
Lack of credit history does not imply greater credit risk, it merely reflects the fact that mainstream credit providers have failed - and continue to fail - to provide them with a decent service. In practice poor people save and pay back their loans, just like people in the mainstream.
In short, the problem of financial exclusion stems primarily from the lack of innovation and lack of customer focus in the mainstream financial service industry. Using statistical scoring techniques is merely a tactic to divert attention away from this fact.
Yet, the government's strategy for tackling financial exclusion focuses on the attempt to expand the role of the mainstream financial service providers where possible; and in addition, to create a low-cost, publicly subsidised safety-net service for those whom remain excluded. Consumer choice and customer service are notable by their absence from this strategy.
In 2007 the Financial Inclusion Task Force asked Experian to identify those areas of the UK where there is a significant mismatch between the demand for and the supply of affordable credit.5 Experian used a market-segmentation model, originally developed as a sales tool for financial services companies to target their products to consumers.6
The very fact that a significant number of the UK population are believed to suffer from financial exclusion should have prompted the thought that the standard marketing tools used by mainstream financial services companies are flawed. Using just such a tool in order to quantify and locate areas of financial exclusion therefore appears rather odd.
Based on its models, Experian ranked over 400 UK Local Authorities according to the presumed level of unmet demand for affordable credit. The highest ranked London Local Authority - Newham - is in 80th position.7
According to data from the 2001 census, there are 37 UK Local Authorities with BME populations above 15% of their total, which is close to double the national average of 8.1%.8 Of these 26 are in London; of the other 11 only four are included in Experian's list of the top twenty Local Authorities ranked by likely demand for affordable credit.9
Now, I think it is possible that many members of BME communities might choose to exclude themselves from the mainstream provision of financial service on the basis that, historically the mainstream has treated them rather badly. So voluntary exclusion might be unusually high among BME communities.
However, Experian's research does not distinguish between voluntary and involuntary exclusion. How could it? Statistical scoring takes no account of customer preferences. By using an inappropriate market segmentation model they have simply written the needs of BME communities out of the equation.
Now, I don't find it particularly surprising that statistical scoring models contain un-stated bias with regard to race and ethnicity; but I do find it surprising that no-one at the Financial Inclusion Taskforce appears to have noticed this fact, and proceeded to base their policy recommendations upon Experian's research.
Some government departments have a more realistic sense of the geography of financial exclusion. When the Department for Business, Enterprise and Regulatory Reform (DBERR) announced a crack-down on illegal money lending in September 2007,10 areas that were listed as a focus for the scheme included Hackney, Newham and Tower Hamlets, here in London. Why? Because these were areas where loan sharks were known to be operating. From which I conclude that the UK's loan sharks have access to better market research than the Financial Inclusion Taskforce does.11
If the government's thinking about the nature and the location of the problem of affordable credit tends to reflect the marketing prejudices of mainstream financial service providers, its thinking about the solution to the problem tends to reflect its own prejudices about standardised, one-size-fits-all welfare solutions.
Instead of trying to create choice as a means to improving quality, the government has hijacked the credit union movement as its lender of last resort. By far the majority of organizations that are currently in receipt of funding from the DWP's Financial Inclusion Growth Fund are credit unions.12 But there are a number of reasons for thinking that credit unions are not particularly well suited to this task.13
The first is that although the credit union movement aspires to promote self- sufficiency within the community, it is becoming increasingly reliant on public subsidy.14 Not only does this risk creating a dependency culture within the credit union movement, it also risks skewing the incentives of credit unions to promote borrowing (which is state subsidised) rather than savings (which are not).
Second, there are concerns about the quality of governance and management at some credit unions;15 and, third, there are doubts about the ability of credit unions to sustain their lending activities when the maximum amount of interest they can charge is artificially capped.16
Of course, it would be unfair to associate all of these problems with the whole of the credit union movement. Some credit unions are very well run organizations that do excellent work in their communities. Some have strategies in place for recruiting members from the BME communities and delivering good quality products and services to those communities.
However, credit unions are based upon common bonds that are mostly defined by geographic area, so the membership of one credit union tends not to overlap with any other. For this reason there is an inbuilt lack of competition between credit unions for their customers: and we know that lack of competition tends to lead to fewer choices, higher prices and poorer services.
So, for anyone concerned about financial exclusion in BME communities there are two significant worries about public policy: first, by using a flawed statistical scoring model, resources have been targeted away from areas known to have significant clusters of BME populations; second, the main strategy for expanding the availability of affordable credit is based on the principle of one local provider in each geographical area, which is hardly a recipe for diversity of provision and consumer choice.
Financially excluded people deserve better than this.17 Providing customers with real choice, appropriate products and a high quality customer services should be the goal. That means new, innovative financial services companies, with access to private sector capital, that will enable them to meet the significant amount of unmet customer demand for affordable credit.
The retail financial services industry in the UK has yet to face the kind of challenge that Easyjet and Ryanair have posed in the air travel industry. But this is exactly what we need. We need a revolution in retail financial service provision, not token reform of the current regime.
1 Simon Blake and Esther de Jong, Short Changed. Financial Exclusion: A guide for donors and funders, p.9, New Philanthropy Capital, July 2008.
2 The importance of this distinction - between those who are voluntarily and those who are involuntarily excluded - is particularly important when we consider financial exclusion amongst black and minority ethnic (BME) communities. There are religious and cultural reasons, as well and social and economic reasons, why individuals might prefer to remain outside of the mainstream; and there are religious and cultural reasons, as well as social and economic reasons, why the mainstream might prefer not to offer services to certain sections of the UK population.
3 For a recent example of this line of argument: "Mainstream banks have little appetite or capability to serve this market effectively, in part because the cost of delivery would necessitate charging APRs of a level that could bring reputational risk. Low income, high-risk consumers have typically been served by high cost credit providers such as home credit lenders or hire purchase retailers", from The Financial Inclusion Taskforce, "Report for the Budget 2009", paragraph 22.
4 Arguably the last couple of years have shown how widespread poor financial capability is in the UK, encompassing significant numbers of Board members and senior executives at our largest banks, and senior managers at the Bank of England, the Financial Services Authority and the Treasury.
5 "Mapping the demand for, and supply of, third sector affordable credit" Financial Inclusion Taskforce, November 2007.
6 According to Experian, they used: "a person-level analytical tool classifying individuals into distinct financial lifestyle types that comprehensively describe their typical financial product holdings, behaviour and future intentions, as well as summarising their key socio-economic characteristics". Presumably Experian do not really believe that they can provide a comprehensive description of the behaviour and future intentions of a single person, let alone the whole population of the UK. What they are offering in practice are generalized guesses about how certain types of people behave and how they might behave in the future.
7 Presumably there is little need for affordable credit in London because, as we all know, the streets are paved with gold.
8 "Minority Ethnic Groups in Britain", Migration Watch UK, 20 December 2004.
9 Of the 11 Local Authorities outside London, 9 make the top 100; of the 26 London boroughs only 4 make the top 100. In other words only 35% (13 out of 37) of those Local Authorities whose BME populations are double the national average are ranked in the top 100 Local Authorities by presumed need for affordable credit, according to Experian.
10 This announcement was made only two months before Experian's research was published. For the DBERR announcement see the BBC Website.
11 Likewise, many of the legal sub-prime lenders prefer to make use of personal contact and local knowledge to expand their customer base, rather than statistical scoring.
12 Department for Work and Pensions, "Growth Fund Contracts", as at October 2009.
13 See, for example, McKillop, D.G., Glass J.C. and Ferguson C. (2002) "Investigating the Growth Performance of UK Credit Unions Using Radial and Non-Radial Efficiency Measures", Journal of Banking and Finance Vol.26, No.8 pp 1563-1591; and more recently, P Goth, D McKillop and C Ferguson, Building Better Credit Unions, Joseph Rowntree Foundation, 2006.
14 According to the website of the Association of British Credit Unions, "Credit unions provide a solution based on self-help rather than state handout; a community owned and community based solution; ...".
15 According to the Financial Services Compensation Scheme there have been thirty-seven credit union failures that have led to default since 2000, that's a rate of four per year.
Poor governance is not just a problem for the smaller credit unions. To give one recent example, the Leeds City Credit Union was bailed-out with £4m of public money in 2008. It's former CEO has subsequently been declared bankrupt. According to recent newspaper reports, the FSA expressed its concerns about Leeds City's governance structure, employment policies, the number of non-standard loans made, and generous loans made to members of staff, as early as 2003. Yet Experian identified Leeds City Credit Union as a flagship provider of affordable credit in November 2007.
16 Academic research suggests that on average credit unions in the UK under-spend on staff costs. Yet it is a feature organizations that work successfully with financially excluded people that they pay a great deal of attention to finding out what their customers want and need. Face-to-face engagement with customers is expensive; it requires that staff be skilled in making credit decisions based on each customer's individual circumstances, i.e. "know your customer".
Currently interest rates for lending by credit unions are capped at 2% per month (an APR of 26.8%). This is almost certainly too low to sustain a lending programme that provides borrowers with an appropriate level advice and support from a loan officer. Many credit unions are only able to lend at these rates because they use volunteers rather than paid staff, or because they have been temporarily gifted capital and running costs from government. (See also Sharon Collard and Elaine Kempson, Affordable Credit, Joseph Rowntree Foundation, 2005, especially page 35, which argues that an APR of around 40% is required for a community lender to become sustainable).
17 In the nineteenth century the French novelist Gustave Flaubert wrote that, "the dream of democracy is to raise the proletariat to the level of stupidity attained by the bourgeoisie". If he were writing today no doubt he would observe that the dream of financial inclusion is to condemn the excluded to the same level of bad service that characterises the financial mainstream.