Pawnshop mentality won’t do, we need new lending models

I recently read the speech given by Jack Ma at the Bund Finance Summit in October 2020. It was shared by the Marcellus Investment Managers team in its newsletter. The speech is now considered to have triggered off a series of events, beginning with the cancellation of an initial public offer by Ma’s Ant Financial, that has led to the ongoing crackdown by the Chinese government on internet companies. However, beyond the political impact, some of the points made by Ma on digital finance in the course of his speech are worth reading in the context of the progress made in Indian digital finance over the past few years.

Ma has thrown firebombs at the traditional financial architecture. One of his targets is what he evocatively describes as the “pawnshop mentality” of established banks, based on collateral, which was necessary for their development but is now at odds with the possibilities of new forms of lending. One part is worth quoting in full: “Collateralization with a pawnshop mentality is not going to support the financial needs of the world’s development over the next 30 years. We must replace this pawnshop mentality with a credit-based system rooted in big data using today’s technological capabilities. This credit-based system is not built on traditional IT, not based on a personal relationship-driven society, but must be built on big data, in order to truly make credit equal wealth. Even the beggar must have some credit; without credit, you can’t even beg for food. I think every beggar is (can be) creditworthy.”

These remarks on the need to move from a lending system based on collateral to one based on big data resonates at a time when India has inaugurated an account-aggregator system, which its enthusiasts say will help small businesses with inadequate collateral or credit histories access credit at far lower rates than they do now. Account aggregators working through a secure public credit registry can do for credit what the United Payments Interface (UPI) has done for retail payments in India.

There is ample research to show that tiny enterprises pay interest rates that are far higher than what their default rates predict, and that is when they can access any form of credit. By easing these credit constraints, the account-aggregator system can potentially engineer a shift from lending based on assets to lending based on cash-flows, at least to small enterprises that have some digital and tax footprints. Lenders can access data on bank statements, GST returns, personal spending, etc, to price loans to enterprises they would earlier stay away from—though hopefully this system is in practice backed with very strong data safety and privacy protocols.

There are two broader macro issues worth focusing on in such new forms of lending. First, can lending based on cash-flows overcome what Tim Besley and Maitreesh Ghatak of the London School of Economics had once called ‘the De Soto Effect’? The reference is to a famous argument by the Peruvian economist Hernando De Soto—that the global poor working in tiny informal enterprises are in effect shut out of the formal credit system, and hence condemned to live in poverty, because a lack of clear property rights makes it difficult for them to offer their land assets as collateral to banks.

A slum dweller with no formal land title thus has to depend on informal sources of money that leave her with little to reinvest in the business. It is quite likely that a successful shift to lending based on borrower cash-flows will ease the ubiquitous credit constraints on informal enterprises. Of course, that still leaves the issue of the sanctity of credit contracts unanswered. Even lenders with rich data on the cash-flows of tiny enterprises will need to be sure that they can get some money back in case of a default.

Second, can the new credit system change the dynamics of structural transformation in India, or the way people migrate from low-productivity to high-productivity activities? There are two ways in which this can happen—one by closing the global productivity gap and the other by closing the domestic productivity gap. The first is the classic pattern observed when people trapped in farms or informal enterprises get employed in large enterprises. This transition has been common in much of Asia east of our borders, but such labour- intensive industrialization has till now not been enough to absorb India’s surplus labour.

The second way is when informal enterprises grow in scale while closing their productivity gap with larger firms in the organized sector. Such a shift from informal to formal is not easy (see Cafe Economics, 26 April 2017, bit.ly/39l7ebY ), but is now part of the national conversation on the overdue formalization of the Indian economy. Credit constraints are part of the reason why small firms fail to scale up in India, though there is also the harsh truth that not all neighbourhood enterprises—many of them a form of distress entrepreneurship—can survive the transition even if their borrowing costs came down. The opportunities that cash-flow-based lending offer can have a profound influence on easing some of the constraints on smaller enterprises which employ most Indians who have left farming behind.

This article was originally published in Livemint on 22 September 2021

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