Can Fintech Improve Financial Inclusion? Adequate Regulation Can Help

November 06, 2017

Regulators in emerging markets face new challenges in an unchartered territory as fintech (financial technology) industries continue to grow and expand in their respective markets. Part of the regulatory challenge stems from the difficulty in pinpointing what exactly a fintech is. Broadly, a fintech can be described as any business that uses technological innovation to provide a financial service or product. This can range from payment and transfer platforms, mobile banking, or insurance services to varied providers of credit, money management, investing, trading, crowdfunding, financial advisory, and more. Clearly, there is a wide variety of models in which fintechs can operate, all bearing varying degrees of risk, which makes regulating them difficult. At the same time, as this industry develops, there is tremendous potential for improving the provision of financial services to large segments of the population by taking advantage of new technological developments. This means that regulators must be proactive to embrace the benefits of new technologies while mitigating risks for consumers. To achieve this goal, pro-financial inclusion regulations need to be compatible with the traditional mandates of financial regulation: stability and integrity of the financial system, and consumer protection.

However, this is easier said than done. It is precisely the difficulties encountered by emerging markets’ regulators in balancing socially desirable innovations and possible risks that are accountable for the slow development of fintech regulations in these economies. To address these problems, the framework developed in CGD’s report, Financial Regulations for Improving Financial Inclusion can support regulators’ efforts. This approach, based on three main principles, encourages the private sector to successfully adopt and adapt digital finance solutions for low-income populations while circumventing risks.

1. Similar regulation for similar functions

The first principle for pro-inclusive digital financial regulation is that of same regulation for similar functions. This can level the playing field amongst alternative providers so that there is fair competition between those offering functionally-equivalent digital services. Fair competition enhances efforts by providers of digital financial services to identify and expand their services to previously underserved individuals and firms. In this context, emerging markets can examine Australia’s FinTech regulatory framework as a model that incorporates this principle. In Australia, regulations depend on the type of business model. For example, marketplace lending providers face varying regulatory obligations based on their specific functions. If a fintech platform is structured as a management investment scheme, where money is collected from various investors and used in a common enterprise, then special licenses are issued and certain regulations may be avoided. On the other hand, if the platform provides consumer credit, then regulations are stringent and the same type of license is required as other credit institutions. This way fintechs can consistently be regulated by their functions, not their institutional forms.

2. Regulation based on risk

The second principle emphasized in the CGD report is that of regulation based on risk, which means that the stringency of regulatory requirements should reflect the risk of the activity in which a fintech is engaged. The greater the risks of the service to users (fraud, abuse, misuse, inappropriate products sold, etc.) or to the stability and integrity of the financial system, the greater the regulatory burden should be. This can be illustrated by examining risk varying activities fintechs may provide. For instance, if a fintech provides a platform that connects individuals (the so-called person to person (P to P) model) to carry out simple payments or transfers, then risks are relatively low. However, if a P to P platform is used in the provision of credit by connecting individual borrowers and lenders, then risks heighten through potentially uninsured defaults, and operational and fraud risks. These risks are further intensified if a fintech is involved in financial intermediation and maturity transformation. In the case of large operations, this can lead to greater financial instability risks in the case of insolvency. As a rule, the closer fintechs’ operations are to those of a banking model, then the greater the convergence should be between fintechs’ and banks’ regulations. This is imperative to avoid financial perils. For instance, in 2015 a Chinese P to P fintech lending company (Ezubao) abused a deficient regulatory framework in China to operate a massive Ponzi scheme, which led to significant losses for many small investors. Since the incident, Chinese authorities have instituted tighter risk-based regulations. Emerging markets can avoid similar financial calamities by applying this regulatory principle to fintechs so that financially inclusive technologies are safely promoted.

3. Balance between ex ante and ex post regulation

Finally, the third principle that emerging markets should implement when designing fintech regulations is that of balance between ex ante and ex post regulation. The focus of this principle is to specify clear rules of the game ex ante and use authority ex post to intervene after a problem or market failure has been identified. This demands that emerging markets regulate fintech based on exposed risks, rather than preemptive speculation. Imposing restrictions too early can inhibit fintech innovation, but acting too late can lead to deep problems, such as system inefficiencies or rooted monopolies. Consequently, the right balance between initial rules and progressively established rules for activities as markets and supervisory capabilities develop is necessary. Emerging markets can study some of the approaches taken in this regard in developed nations thus far. For instance, Singapore has taken the regulatory “sandbox” approach to help providers and regulators to learn from their interactions and market developments in a more controlled and secure environment. Here, regulators restrict the operating space and time of fintech until their safety and soundness is determined. Once the risk level is assessed, then the regulator can approve or deny the fintech’s participation in the market.

A unique opportunity for financial inclusion

Current fintech developments present a unique opportunity for the promotion of financial inclusion and stability in emerging markets. However, without the appropriate regulatory framework for these developments to advance, the benefits may not be fully experienced. Some emerging markets have already begun to act upon this realization, as with Mexico—the first Latin American country to draft a fintech law. This law aims to regulate the rapidly growing fintech industry in Mexico. It still stands to be approved by Congress so its potential applicability to other emerging markets cannot yet be assessed. As Mexico and other emerging markets continue to move forward in their efforts to regulate fintech, the recommendations in the CGD report can serve them well.


CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.