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Building Financial Identities For Small Businesses

Gravity Earth explores the ways in which financial identities can support Micro, Small & Medium-Sized Enterprises (MSMEs)

Kamau is the owner of a duka (corner store) in the Ongata Rongai area on the outskirts of Nairobi. Recently, due to heavy rains which caused a leakage in the roof of his shop , a significant amount of his stock of flour went bad before he could sell it. To add to this, he also had to pay to fix the leaky roof. He now wants to purchase another stock of flour packages from the distributor, but the loss in sales and the cost of repairing the roof have left a dent in his cash reserves. He needs a loan to help him smooth his cash flow, but his options are limited.

Kamau’s story is shared by thousands of other duka owners across Kenya.

Zooming out, lack of access to credit is a major constraint for around 70% of all Micro, Small & Medium-sized Enterprises (MSMEs) across Sub-Saharan Africa. The most recent estimates show that across the continent, MSMEs’ demand for credit exceeds its supply by US$ 330 billion (IFC 2017), but the actual figure could be much higher.

Let’s go back to Kamau’s problem and consider the options available to him:

  1. Borrowing from a bank could give him both the amount and maturity period needed. But he would have to close his shop to apply in person, while facing the risk of rejection because he doesn’t have the necessary documents.
  2. He can borrow from family and friends, but they themselves may not be in a position to lend him the amounts he requires.
  3. Loan sharks could lend him the amount he requires, but they charge extremely high interest rates and provide short maturities.
  4. Digital lending is a quick and easy option, but again, the amount, maturity, and interest rates might not suit his business needs. Further, he’s afraid of what might happen if he doesn’t pay back on time.

Why can’t Kamau borrow?

Kamau’s limited options point to the lack of availability of financial services and products that specifically address the situation of MSMEs. This lack of availability is puzzling when we consider the size and the potential of the MSME segment. Why, then, don’t banks and other financial institutions want to target them?

The answer to this points us to a much larger systemic failure: information asymmetry.

The absence of reliable and verifiable information about the business owner and the business’ performance is often a dealbreaker for lenders. To add to this is the lack of assets against which the loan can be secured. Lenders are not only left without the means of assessing the risk of lending to the business owner, but also with limited options for recovering the amount lent. Further, the capacity of formal credit information sharing systems to include this invisible segment is also limited.

Over the last year, we reached out to several different types of lenders such as banks, microfinance institutions and digital lenders to understand the constraints and incentives they faced when considering lending to the MSME segment. We found that, while interest in lending to MSMEs was present across the board, it was not being translated into researching and designing MSME-oriented products. Most lenders confirmed that the lack of verifiable data was indeed the main deterrent. However, cost recovery and profitability were also major concerns.

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Why do lenders lack this information about MSMEs?

MSMEs are at a disadvantage in terms of providing this information to lenders because of their generally informal nature and lack of borrowing history and assets. But lenders are finding ways to address these issues as well. We narrowed down 3 criteria which lenders consider as the bare minimum to potentially lend to this segment:

  1. Know Your Customer (KYC) details to prevent fraud and meet regulatory requirements,
  2. Business performance in terms of stock purchases and cash flows, and
  3. A basic borrowing history, either through a credit bureau record or through previous loans taken out by the individual.

The increasing move towards a digital economy in Kenya means that all this information exists in the form of data trails for many MSMEs. But these data trails exist in silos with different parties.

Let’s look at Kamau’s case again to understand the problem of siloed data. Kamau has previously taken out a digital loan using a mobile lending app. This could provide insight into his tendency to repay the loan. However, details about the loan and its repayment are held by the mobile loan provider. Further, this data may not be enough for lenders to determine how his business is performing and thus his capacity to repay. That information could be determined by looking at his stock purchase history with his various suppliers and distributors. In isolation, none of these different data trails help paint a complete picture of Kamau and his business. Lenders must therefore find a way to access these different data trails so that they can assess Kamau’s case holistically.

A user-centric financial identity can address information asymmetry

A user-centered and digital financial identity could help lenders, and more importantly small business owners like Kamau, to take advantage of dispersed data trails by combining them in one place. Lenders can then use this financial identity to make a better informed, data-driven lending decision.

Over the last year, we have been using our digital identity platform to help shopkeepers in Nairobi access affordable working capital loans by building cohesive digital financial identities. Each shopkeeper is equipped with a digital wallet accessible via a mobile or web app, or a USSD menu. Organizations that have data about shopkeepers, such as distributors or identity verification services then submit this data to the shopkeeper’s wallet. When a shopkeeper wants a loan, lenders can request access to the relevant data through our platform directly from the shopkeeper.

Such a solution helps resolve the information asymmetry that arises from siloed data. But it also raises several important questions:

  • How can lenders be sure about the origin of the data?
  • How would we ensure that data sharing at this scale does not violate the privacy and security of vulnerable populations?
  • Who would bear the responsibility of ensuring data protection and privacy? Would it be the organizations collecting it, the lenders, or a third party such as a public actor?

The value added by decentralized identity

We have been using decentralized identity to help address the above concerns. By putting the data subject, i.e. the shopkeeper, at the center of the data sharing equation, decentralized identity has a number of benefits for all stakeholders involved.

Firstly, decentralized identity allows lenders to be sure of the origin of the data. Each piece of data is digitally signed by the issuer of that data. Secondly, lenders are only able to access the required data once the business owner has granted consent. This is especially important when we consider the vulnerability of a vast majority of the MSMEs we are working with. It also helps mitigate concerns which data contributing organizations have around violating data privacy regulations, especially given the pace at which these are evolving and being introduced. Thirdly, and most importantly, the solution makes the small business owner the custodian of their own data. This means that they themselves become the access point for all data sharing, increasing privacy and data security, and enhancing consumer choice .

This combination of verifiability, privacy and user control makes decentralized identity the most promising way of piecing together this puzzle. On one end it helps solve the systemic problem of information asymmetry through data sharing. But it also goes a step further by pre-empting the range of issues which could arise from data sharing for vulnerable populations at this scale.

In an increasingly digital economy, a user-controlled financial identity could help accelerate financial inclusion by empowering millions of small business owners like Kamau.