Harms to Consumers in a Modular Financial System

By Beni Chugh & Nishanth K, Dvara Research

This post is part of our blog series on the Conference on Designing Regulations for a Rapidly Evolving Financial System hosted by Dvara Research (formerly known as IFMR Finance Foundation).

In the previous blog posts, we discussed what we mean by Modularisation of financial services, and we looked at the strategic evolution of business models in order to efficiently deliver financial services to benefit consumers in a modular world. However, it is necessary to balance this promise of efficiency in a modular financial system with the potential risks that could manifest. In this blog post, we explore the potential concerns for consumer protection regulation that have emerged directly or indirectly as a result of Modularisation. The unbundling of the processes associated with the manufacturing and distribution of financial products may amplify existing consumer risks as well as create new risks and harms to the consumer. In India, the typology of consumer harms in financial sector is informed by the Financial Sector Legislative Reforms Commission[1]. The understanding of harms is founded on the premise that a consumer has some rights and that the infringement of these rights has a negative consequence for the consumer, which we understand as ‘harm’. FSLRC identifies the following consumer harms:

  • Unfair conduct
  • Unfair contracting terms
  • Inadequate disclosure
  • Inadequate redress
  • Unsuitable advice

The challenge facing regulators and policy makers today is to anticipate and guard against new kinds of consumer harms that could be caused by Modularisation, while also ensuring that existing harms from traditional models are not amplified and are brought under control. In particular, the use of digital technology for delivery of financial services which catalyses the trends of disintermediation in financial services, creates new harms for the consumer. Below, we elucidate these specific harms:.

  • Harms due to technology failures: Given the amount of data collected, stored and transmitted digitally in the payments process, there is an increasing threat of security failures which may result in financial or data loss. The absence of hardware checks for mobile phone handsets or universal regulations limiting pre-installed applications on mobile phones opens up the possibility for phones manufactured in other countries becoming hotspots for data theft and spyware.
  • Harms due to inadequate redressal: Modularisation increases the number of firms involved in a financial transaction. A modular financial system with several players working together to provide financial products and services would mean that there exists a variety of different consumer touch points for the delivery of the product. It would also be the case that several institutions would play a role in the design and delivery of the product. This would create an ambiguous environment for the consumer to identify which institution he or she must approach for redressal[2].
  • Harms due to Obsolescence: With this rapid pace of innovation comes the threat of obsolescence—both of hardware and software technologies—that users require to access services. Obsolescence may create a barrier to service delivery by excluding certain consumers from access. It could also disrupt service delivery to existing customers from incompatibilities that arise following technology upgrades. This creates additional costs for the consumer.

By harvesting data where traditional data is absent, the new ‘modular’ businesses are being able to tap market segments that were previously untapped or underserved. In order to fully understand the implications of data driven models for consumers, it is important to understand the working of these data-based businesses. One particular case indicates how data driven models could harm consumers. In 2015, a study pointed out that the price of The Princeton Review’s Online SAT programs differed according to the ethnicity of the consumer[3]. Asians were being systematically charged twice that of the American consumers, and the customer profiling was based on zip-codes. This presents a new harm of discrimination, raising important public policy concerns. While discrimination is a consequence of the algorithmic ability of businesses to efficiently segment populations, the sheer handling of large sizes of personally identifiable information itself, could be a source of harm. We classify these harms as follows:

  • Harms from Market Exclusion: Though alternative data today is enabling financial inclusion where traditional data does not exist, the unanticipated aggregation of person’s data from multiple sources to draw adverse conclusions about the individual poses a real harm. For instance the possibility of financial exclusion due to new data practices can lead to market “segmentation” or “customisation”. This could systematically prefer one segment and unfairly discriminate against the other.
  • Harm to individual liberty: Even when the access to big data is authorised, personal and sensitive information like geolocation or political affiliation could be used to the detriment of the individual. This is especially plausible in jurisdictions where data processing laws are not transparent enough or the rule of law is not strong enough.
  • Harms due to untested design of algorithms: Decisions based on untested algorithms could well be inaccurate or unfair. Algorithms typically work like black boxes and often result in unknowable conclusions which may lead to bad outcomes for consumers of businesses using such algorithms.
  • Privacy Harms: At the level of the individual, the interconnectedness of data sets increases the risk of unauthorised use of personal information like biometrics.
  • Harms due to the ability to differentiate: The extreme efficiency of big data to differentiate among individuals can jeopardise important social benefits. For instance the ability to distinguish between individuals based on their susceptibility to health issues and systematically excluding them from insurance products could attack the foundation of risk-pooling itself. This will leave the most vulnerable individuals out of insurance markets, an outcome that societies do not desire.
  • Harms due to constant surveillance: Constant surveillance is known to reduce the ability of humans to engage in independent, creative and innovative thoughts.
  • Harms due to permeable group privacy: Though some people in a group may seek to maintain their privacy, their privacy could still be breached because individuals similar to them have revealed their preferences. The ability of big data to analyse and infer can lead to weaker privacy for even those individuals who value it more than the rest.

A better understanding of these harms is necessary for us to better inform policy and regulation for consumer protection. While the potential benefits of Modularisation in financial services to the consumer and emerging businesses are widely acknowledged, it is quintessential to balance them against the risks posed to the consumer. In the next post, we shall look at concerns that Modularisation raises for prudential regulation.

[1] MoF (2013), “Financial Sector Legislative Reforms Committee (FSLRC) Report”, Ministry of Finance
[2] Modularisation further bolsters the argument for the creation of a cross-sectoral Financial Redress Agency as an exponential growth in complaints is likely to be happen. This agency should be able to overcome inter-regulatory challenges and regulatory blind-spots in harmonising consumer protection rules and rights along with the legal capabilities to enforce punitive sanctions on market participants.
[3] Vafa K, Haigh C, Leung A, Yonack N. Price Discrimination in The Princeton Review’s Online SAT Tutoring Service. Technology Science. 2015090102. September 1, 2015. (https://techscience.org/a/2015090102)


Mapping Modularisation in the Financial Services Industry

By Nishanth K & Madhu Srinvas, Dvara Research 

This post is part of our blog series on the Conference on Designing Regulations for a Rapidly Evolving Financial System hosted by Dvara Research (formerly known as IFMR Finance Foundation).

In a previous post of this series, we introduced the recent trend of ‘Modularisation’ that formed the basis for the deliberations at the third Financial Systems Design Conference. Moving away from the traditional model of service delivery where financial institutions perform all the functions associated with the delivery of a product to a consumer, the trend of Modularisation has seen the emergence of specialist institutions that perform only a subset of the universe of functions that were traditionally performed by a single financial institution, and many such specialist institutions together combine to offer a financial service to the end-customer. It is to be noted that Modularisation goes beyond the use of specialised intermediaries for certain functions such as cash management or loan sourcing, which is common practice in traditional financial services delivery. For instance, the sale of a credit product may now involve online aggregator platforms that create and manage the relationship with the consumer. Borrower verification and risk assessment may involve multiple firms such as credit information companies and data analytics firms. Product design may involve a lending institution with specialised knowledge of the particular customer segment and an eventual financial institution that aggregates the risk and provides the balance sheet resources. This presents new opportunities for consumers and new entrants while introducing new challenges for incumbent institutions as well as for the regulators overseeing the functions under question.

Strategic Evolution of Business Model Archetypes

Modularisation has brought in its wake disruptions to traditional business models in financial services. This is due to:

  1. The decoupling of manufacturing and distribution functions and the creation of marketplaces that move away from one-to-one to many-to-many principal-agent relationships;
  2. The embedding of financial product delivery into both offline and online real sector businesses, resulting in the blurring of the lines between financial and non-financial service delivery.

One of the ways to understand Modularisation in financial services is to segregate the functions of a financial service provider into two broad categories: Product Creation and Product Distribution. We visualise this distinction by classifying the emergent business models into four categories, as described in the Report[1] by Oliver Wyman titled “Modular Financial Services: The New Shape of the Industry”.

Source: Oliver Wyman

  1. Vertical Integrator – This category represents a fully integrated institution which handles all functions from product creation to the delivery of product and its servicing. Universal banks are an example of a vertical integrator.
  2. Component Supplier – This category represents institutions that design the financial product but distribute through third party institutions. A typical example is a bank using business correspondents to originate loans.
  3. Demand Aggregator: A business correspondent is a typical example of a demand aggregator. It distributes products and services which are designed and manufactured by another institution.
  4. Platform Provider: In a fully modular environment, a platform provider links customers to multiple suppliers. The tasks involved in the manufacturing and distribution of financial products are performed by a variety of specialist firms. The platform provider links firms providing various functions such as product design, risk analytics, back-office operations, payments, balance sheet management and so on to cater to the end customer.

The Component Supplier and Demand Supplier models have enabled the embedding of financial products into the retail commerce sector. These modularised models of finance enable the sale of credit and insurance products along with the sale of goods on platforms such as e-commerce websites. A typical example of a platform provider in India would be an e-commerce platform such as Flipkart or Amazon that enables the sale of credit products along with the sale of retail merchandise. This integration allows the consumer to avail extremely customised products through a seamless delivery experience.

To set the context for the Conference, Duncan Woods, Partner at Oliver Wyman, led the introductory session on mapping this recent trend of Modularisation (See video below). He also covered business models that are shaping the ‘modular’ financial system and elaborated on their potential in serving the un/under banked segment.

Benefits to the Consumer

There are several factors that have motivated the trend of Modularisation in the financial services industry. Most important among these, is that Modularisation of financial services will potentially benefit the consumer in multiple ways:

  • Providing convenient and efficient services:. The emergence of the digital medium as a powerful channel for the delivery of financial products has enabled the consumer to have access to financial products offered by a multitude of providers. Firms such as e-commerce websites and social networking sites are now leveraging their existing relationship with the consumer to provide financial products. Service providers are now able to access relevant and clean sources of data on consumers through APIs which are enabling the provision of easier and more targeted and customised services. This availability of on-demand and holistic financial services through digital channels is allowing these newer firms and channels to challenge the traditional brick-and-mortar banking model.
  • Enabling access to customised products at reduced costs: The unbundling of processes involved in completing the delivery of a financial product has provided financial institutions the choice of employing specialised institutions in a manner that significantly reduces operating expenses. This, coupled with existing cost-effective and scalable technologies in financial services, is bringing down the costs associated with the delivery of products. For instance, in the case of credit, online origination platforms are able to reduce loan processing and underwriting costs. This may enable financial services providers to offer smaller-value loans to households and small businesses in a more cost-effective manner. This may permit better alignment of products to the preferences of these consumers.

In subsequent posts, we explore challenges for regulation in a modularised world.

[1] Modular Financial Services: The New Shape of the Industry, Report by Oliver Wyman, 2016 (http://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2016/jan/OliverWyman_ModularFS_final.pdf)


Designing Regulations for a Rapidly Evolving Financial System – Financial Systems Design Conference 2017

By Nishanth K & Madhu Srinivas, Dvara Research 

Dvara Research (formerly known as IFMR Finance Foundation) held its 3rd Financial Systems Design Conference on August 4th and 5th, 2017 in Chennai India. The two-day Conference brought together a carefully curated group of regulators, academics and thought leaders in financial services to examine the trend of Modularisation and its implications for regulation design for the Indian Financial System.

Modularisation is defined as the unbundling of the financial services value chain into different modules. Traditionally, financial services industry has been populated with institutions that perform all the functions associated with the delivery of a product to a consumer. From the on-boarding of the customer to the delivery and servicing of the product, a majority of, if not all, the functions associated with the sale are performed internally within an institution like in the case of full-service banks.

The recent trend of firms engaging in only a specific part of a financial transaction typifies the growth of Modularisation in the system. In a modular financial system, each module contains a set of functions which may now be performed by different institutions. This allows specialised firms to combine their offerings together and provide a financial product to the end customer.

This unbundling of services could potentially benefit the consumer in multiple ways. However, regulation would have to evolve to mitigate any amplification of existing consumer risks as well as new risks to the consumer because of modularisation. Additionally the regulators would also need to be aware of the implication of modularisation on systemic risk.

Given the above context, the Conference hosted a set of sessions that covered a discovery of potential impacts, benefits and harms to consumers from Modularisation, as well as implications for prudential and customer protection regulations for the modular world, led by experts from India, US and Australia.

Conference Participants

The conference was structured in a manner conducive to addressing the following questions at its core:

  1. How Modularisation has been shaping, and could potentially shape the financial services industry?
  2. How should regulation respond to the trend of Modularisation?

The Conference yielded rich discussions and the participants identified several interesting issues and priorities for the Indian financial system. The Conference website contains the agenda and the profiles of participants. We will be in the coming days releasing the conference proceeds, and through a series of posts detail the insights that came out of the discussions at the conference.


Insights from the “Digital Investments Roundtable” hosted by the Future of Finance Initiative

(This post is authored by the Future of Finance Team at the IFMR Finance Foundation).

In the first and second posts of this series on the three Future of Finance Initiative (FFI) workshops hosted in April, we focused on digital payments and digital credit respectively. This blog summarises the key insights from the third workshop on digital investments. The workshop was attended by providers with a strong digital interface from across the investments ecosystem in India. We thank the participants for their frank and open views presented at the discussions.

The retail investments landscape in India is currently in the process of being disintermediated with the operating model of traditional providers and associated intermediaries being relooked at by fintech players in this space. Given this background and realising the continuing need for high-quality investment products for rural low-income households, we wanted to understand:

  • How are providers providing solutions relevant to new market segments?
  • Where are the risks and vulnerabilities across the chain of the players and processes associated with making digital investments?

In doing so, we found ourselves asking the following questions of the curated group of participants:

  • How are providers dealing with any issues around (a) segregation of investments advice and product sale, and (b) customer data protection?
  • What are the operational pain points for providers which are either created by or can be solved by policy and regulation intervention?

The first session at the workshop focussed on the current state of digital investments in India and was used to frame the discussion. An interesting visual from this discussion (reproduced below) was the geographic distribution of mutual funds sales in the country, which reveals that Western and Southern states have generated the majority of such investments. It was pointed out that in contrast, the penetration of life insurance is better in eastern parts of India. However, despite the growth of the mutual fund industry being significant in terms of absolute numbers, as a percentage of GDP, it is still estimated to be very low at 8.4% (as of 2016).[1]

Graphic: Geographic spread of mutual fund products (Source: Association of Mutual Funds in India) (Note: Legend in the graphic pertains to the average assets under management in Rs. crore)

Views on the future trends in the investments space and the role of regulation

Both offline and online consumer interfaces will continue to be critical: There was consensus among the participants that hybrid business models, incorporating both online and offline product distribution channels would prevail in the near future. It was however noted that there is a supporting environment in the form of digital public infrastructure (such as Aadhaar and India Stack) which has provided impetus for digital transactions in this space and that technology has enabled almost real time access to investments which was previously not the case.

The need for differentiated KYC processes: Some of the participants questioned the need for completing the full ‘know your customer’ process (including ‘in-person verification’) as a pre-requisite for investments in mutual funds since investor funds were moved from a KYC compliant bank account of the investor to the asset management company. One of the suggestions in this regard was to make full KYC a pre-requisite to redeem mutual fund investments and also put in place risk based KYC processes instead of uniform KYC processes irrespective of the nature and amount of investments.

On the role of industry standards and sector practices: The participants noted that there are currently no regulations regarding protection and security of an investor’s personal data which apply to entities operating in this sector. Some of the participants highlighted their internal best practices such as conducting vendor due diligence before sharing personal data and having robust data security protocols driven in part by shareholder requirements (especially for companies which have received venture capital funding).

On complaints mechanisms: The participants agreed on the need to strengthen grievance redressal mechanism to ensure better investor outcomes and suggested that investor awareness programmes (which are applicable to product manufacturers) be made outcome based, for instance by measuring the number of retail investors which take up mutual fund investments as a result of participating in or being exposed to awareness programmes. It should be noted in this regard that the Securities and Exchange Board of India (SEBI) currently requires depositories and asset management companies/registrar and transfer agencies to put in place ‘proper grievance redressal mechanism’ that is required to be communicated to the investors through the consolidated account statements.[2]

Role of agents and robo-advisory in the context of investment products

On treatment of advice and sale: Participants were keen to discuss the policy focus on separating advice and sale of investment products and commented that SEBI should consider regulating the quality of advice provided by agents. It should be noted that SEBI had recently put out a Consultation Paper on Amendments/Clarifications to the SEBI (Investment Advisers) Regulations, 2013 (available here) in this regard.

Some of the participants took a view that the current Indian market for portfolio advice is not at all data driven and potentially harmful advice is being provided to investors. It was also pointed out that the pass-through of commissions (received by insurance and mutual fund distributors) to investors is a rampant practice in India.

The promise of some of the new developments and digital investments is that more data flows can improve the range and quality of service in this space.

On considerations for robo-advisory services: The role of robo-advisory, i.e., providing financial advice with minimal human intervention, in investment advisory was also discussed. These advice algorithms could add value in terms of customising advice for consumers. There was recognition that training algorithm based investment advisory could retain the biases of human advisors which needed to be addressed in the long term and there were questions around the manner of selection of funds recommended by robo-advisors.

On disclosure: There was general consensus in the room that the onus should be on advisors to read offer documents and other disclosures and give informed advice to investors, instead of expecting potential investors to do so themselves.

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect citizens accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.

[1] Attributed to Mr. NK Prasad, President and CEO at Computer Age Management Services Private Limited. Please see MF investments rising in smaller towns: CAMS, The Tribune, 28 December 2016. Available at: http://www.tribuneindia.com/news/business/mf-investments-rising-in-smaller-towns-cams/342616.html.
[2] As per paragraph of the SEBI Master Circular for Mutual Funds, 2016.


Insights from the “Digital Credit Roundtable” hosted by the Future of Finance Initiative

(This post is authored by the Future of Finance Team at the IFMR Finance Foundation).

In the first post of this series on the three Future of Finance Initiative (FFI) workshops hosted in April, we focused on the workshop on digital payments. This blog summarises the key insights from the second workshop on digital credit. The workshop was attended by  providers  from across the credit ecosystem in India. We thank the participants for their frank and open views presented at the discussions.

India is one of the most underserved credit markets in the world, with only 15% of the households borrowing from formal channels.[1] Emerging digital lending models have the potential to address this gap. These models range from online marketplaces and online lenders (originating loans on behalf of traditional institutions or lending themselves) to P2P players (connecting individual lenders to borrowers via a platform). Given the entry of all these new technology oriented providers and intermediaries, we wanted to understand responses to our core questions to players across the digital credit space:

  • How are providers providing solutions relevant to new market segments?
  • Where are the risks and vulnerabilities across the chain of the players and processes in the digital credit ecosystem?

The Growing Role of Non-bank Entities in Digital Credit

An early insight that participants shared at the workshop was that there is no shortage of demand or supply for credit in India today, rather that we lack mechanisms in the market for the appropriate deployment of supply. It was also emphasised that role of fintech providers in India is fundamentally different from markets like the US: while fintechs in US focus on a generally well-banked population often in competition with established banks, Indian fintech firms are also trying to expand the market and provide services to the underserved.

The key question facing the Indian market is whether providers dis-intermediating the chain of credit will partner with banks or compete with them in order to provide services to customers. Two market trends described within this context:

a) P2P lending platforms partnering with banks

Participants reflected that traditional banking is limited by legacy systems and regulations. Some banks have taken a progressive view of the developments, with early trends emerging of P2P platforms tying up with banks to source customers and help with the early stages of the customer verification process. These partnerships are making certain assets classes—such as consumer and SME loans through e-commerce platforms—more accessible to traditional banks.

b) New strategies by digital lenders and P2P platforms to reach customers not previously accessed by traditional lenders

Providers in the digital credit market are also using new strategies to diversify the base of customers to whom they lend such as building partnerships with e-commerce platforms to use their data and advertising and targeting new customers. For instance, some P2P platforms have tie-ups with travel and holiday planning sites to offer loans to vendors listed on the site.[2] These partnerships have opened up access to new customers for SME and consumer loans who may not have been previously accessible to lenders.[3]

New Service Providers in the Chain of Digital Credit

Next the discussion moved on to the range of players in the digital credit scene. To frame the discussion, we presented a list of all the stakeholders involved in the provisions of digital credit to the participants (Table 1) – based on our understanding of the credit ecosystem.

Table 1: Digital Credit Stakeholders

Source: FFI (2017)

The participants observed that the above list is likely to evolve as emerging players involved in providing digital credit and related services are currently discovering and experimenting with different business models.

Despite the changing nature of the industry, participants agreed that the majority of digital credit operations are the same as those in traditional lending. However, certain processes such as risk origination and risk assessment have evolved because of increased access and use of customer data.

Emerging Pain Points for Digital Credit

The discussion moved on to the operational pain points faced by providers and their intermediaries.

Low awareness of data-related risks: The chief concerns of the attendees centred on data protection and privacy. The participants felt that the average Indian consumer’s awareness of data related risks is minimal. Educating customers about privacy and data protection issues is crucial. The providers at our workshop took their own roles in this process very seriously. Participants also believed that customer data should not be shared without explicit consent. However at the same time, they conceded that it is often unclear for consumers to know what they are giving consent for.

Participants also highlighted that risky customer data practices already exist and are not unique to the digital credit space. For instance, participants discussed the large role that Direct Selling Agents (DSAs) have traditionally played in the selling of financial products by contacting potential customers. Currently, DSAs are a weak link when it comes to securing customer data, since there is no clear procedure to monitor and sanction these agents.

New data for credit assessments: Next the participants discussed the use of alternative data based assessment for lower income customers – to widen the potential to offer credit products to them since they often do not have more traditional credit scores to support assessments of credit worthiness. It was emphasised that standardised credit products can lead to financial exclusion due to exclusionary eligibility criteria.

In this context, the question of privacy arose – specifically, whether certain types of alternative data could compromise the privacy of individuals and whether this was a valid consideration. Participants’ views were divided on the importance of this question to the end customer – with some musing that privacy could be a “luxury” problem and others priding themselves on placing strong value on their data privacy practice.

Need for standardised borrower assessment, fair lending requirements and front end provider liability: Typically, assessing a borrower’s credit worthiness involves gauging the ability to repay, intent to repay and identity. This process is standardised in countries like the US and the UK. However, in India there is no standardisation of the borrower assessment process. This exacerbates the challenges of evaluating customers.

In the US, the fair lending requirements practised by foreign banks prevent discrimination based on pincode, race etc. Equivalent provisions do not currently exist in India. However, in the US, discrimination is implicit within lending practices — in a black box form. As a result, American lenders do not share their assessment processes.

All the participants agreed that in the case of any customer harm arising, the customer-facing institution must take responsibility and liability — irrespective of the dis-intermediation of the chain of credit in the digital context. There cannot be a situation where the customer’s rights are spread across multiple entities.

Regulators need to factor in market development and stakeholder perspectives: Participants highlighted the need for regulators to let the industry take a meaningful size and shape before introducing guidelines. If regulations supersede the industry’s development, they can shape the formation of industry (instead of market forces).

The attendees also remarked that digital lenders have no formal forum for engagements with key regulators, making it tough for them to feedback ex ante about the possible impact of proposed regulation on the market and on customers. One recent initiative that participants discussed was the Digital Lenders Association of India (DLAI), which seeks to work closely with the government, regulators and policymakers on behalf of those involved in core lending business and facilitators in digital lending.

Overall, the workshop helped us get an insight into the role of the various actors who participate in the digital credit ecosystem in India, and their perceptions on managing risks to customers.

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect citizens accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.

[1]See: All-India Debt and. Investment survey (2014) http://mospi.nic.in/sites/default/files/publication_reports/nss_577.pdf
[2]See: http://www.business-standard.com/article/companies/alok-mittal-returns-as-entrepreneur-launches-platform-for-smb-lending-115100100047_1.html
[3]See: http://www.amazon.in/b?ie=UTF8&node=8520691031