Fast Track to Financial Inclusion

Financial institutions in Pakistan largely exist as a conduit to raise deposits from people and lend to the government. The government is effectively the biggest customer, gobbling up more than 60% of the total capital available with financial institutions for investment or lending purposes. The existence of such a lopsided structure, wherein the government is scrabbling for additional funds to bridge its perennial fiscal deficits, leads to a situation where financial institutions wield power to set the interest rates (the cost of borrowing) for the government. Furthermore, since lending to the government is relatively risk-free, financial institutions are happy to lend to the government and not bother with riskier stuff like actually lending to the private sector and stimulating investment.

In such a scenario, there is little incentive for legacy financial institutions to differentiate their product offerings or services for a better customer experience. This has led to a market structure whereby all participants are fine with their market shares and little effort is put into enhancing the customer experience, be it on the product development side or the service quality side. With the government as the largest borrower, regardless of the service quality or product sophistication, any investment in product differentiation eventually leads to a lower return on capital. Why bother to create cutting-edge products, or at least products comparable to other markets in peer and developed economies, when doing so would lead to a lower return on capital? Complacency sets in, which slows down the growth of the sector as well as product evolution.

Even in capital markets, growth has been muted. The number of people investing in them has remained flat for the last 15 years, while barely any new products have been launched to improve the sophistication of the market. The inability to improve trading platforms and processes has resulted in a situation where the capital markets are at the mercy of a handful of retail and institutional investors, which eventually hurts market integrity. In such a scenario, the ability to raise capital from capital markets remains compromised as complacency becomes the order of the day.

A broken market structure dominated by legacy financial institutions held back by ineptitude and complacency creates a massive opportunity for emerging financial institutions with a focus on technology (fintechs). These fintechs do not have the luxury of the excess capital made available to legacy financial institutions but are also not bogged down by legacy processes and decision paralysis. Benefiting from a nimbler and asset-light approach, fintechs have the ability to enhance the overall customer experience, improve product offerings and, more importantly, reduce customer acquisition costs (relative to legacy financial institutions). Some of the opportunities that exist for fintechs can be split into the following areas.

Payments: These are the lowest-hanging fruit. Currency in circulation in Pakistan is at 18% percent of the GDP and has consistently grown over the last 10 years. Incentivising payments that are routed through digital channels via policy and technological interventions can increase the pie substantially. Pakistan is a predominantly cash-based economy and herein lies the opportunity. Although it may not be as remunerative (any entity would eventually have to compete with cash which has zero cost), it will eventually be possible (whether through better efficiencies or tailored products) to not only expand the payment pie but take a major share of it. Eventually, legacy financial institutions will transition out of payments, and dedicated payments entities powered by evolving technology will take control of the payments pie.  

MSME Lending: As government borrowing has crowded out private sector borrowing, the penetration of legacy financial institutions within the MSMEs (medium, small and micro enterprises) has been minimal, resulting in a substantial funding gap. This is estimated to be worth four trillion rupees and it continues to grow every year. The reluctance of legacy financial institutions to enter this segment can be attributed to higher customer acquisition and management costs, and risks. However, for fintechs, it is entirely possible to reduce customer acquisition costs by scaling up in specialised segments and initiating cash flow-based lending. By leveraging technology platforms and creating digital payments and flow linkages, fintechs can reduce acquisition and management costs, while tapping a largely unexplored segment. This has already been successfully executed elsewhere and it is only a matter of time before someone cracks the code here. A word of caution pertains to the high default risk associated with the segment, although a carefully calibrated growth approach and a heightened focus on credit risk (often ignored by many) can hedge against the dangers of default which affect this specific segment.

P2G Lending: The government has insatiable borrowing requirements and they are only going to increase in nominal terms as overall GDP increases. Currently, the biggest borrower uses banks as conduits to effectively use depositor money while banks make a sweet interest rate spread. It is entirely possible for the government to borrow directly from the public if technology is effectively leveraged. Such a structure would considerably reduce the cost of borrowing for the government, while giving depositors a relatively higher return, resulting in improved outcomes for both key stakeholders. Meanwhile, the technology platforms enabling this can play with massive volumes, amounting to trillions of rupees and create a more efficient debt market which can expand the market for debt securities and provide additional revenue streams.  

Capital Markets: Pakistan has one of the lowest savings rates in the world, which is largely a function of the absence of a robust capital market with product depth and breadth to cater to varying needs. In such a scenario, households prefer to save in real estate, gold or cash. A key factor hindering growth has been the distribution costs and the cannibalisation of legacy financial institutions; most asset management companies are already subsidiaries of legacy financial institutions and any innovation or product development poses a threat to their core banking model. Fintechs exclusively focused on wealth and financial planning, which can deliver tailor-made investment products that can tap a largely unexploited market. There is no competition in this territory and it is up for grabs. Similarly, fintechs focusing on asset management or exchange platforms can expand the size of a very small market as well and make legacy financial institutions irrelevant. Banks still have a strong presence and deposit franchise whereas no such comparison exists in the area of financial planning or investment management.

Pakistan has fairly low financial inclusion compared to similar economies. Even for the financially included, exposure to even marginally sophisticated products is not an option. Fintechs can bridge that gap and capitalise on an undeveloped market that legacy financial institutions consider too risky. The secret ingredient is the intermingling of the right talent which understands finance and talent which understands technology – any fintech that is able to successfully get this mix right can become the first unicorn of Pakistan.  

Ammar H. Khan is a macroeconomist. ammar.habib@gmail.com