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Written by Aman Srivastava   
Monday, 14 February 2011 05:32
As policy makers pursue financial inclusion to ensure socio-economic development, Aman Srivastava of Indicus Analytics deconstructs the
complexities of the goal, taking stock of the situation and the need to take a proactive approach, in the first article of this three-part series

Source: Financial Express Dated 13th February, 2011

Financial inclusion as a goal is gaining greater attention in government policy circles and is a key to continued socio-economic development. Almost 3 billion people around the world lack access to basic financial services that have the potential to transform economies and boost livelihoods. Such is the importance of this issue that it was a leading topic of discussion at the annual World Economic Forum meeting last month. 

There is an urgent need for understanding the complexities of this goal, so that the regulation required to achieve it is proactive and not reactive, and can encourage large-scale participation. This topic thus merits a greater understanding and discussion, which we endeavor to commence here. The series begins with an overview of the current state of inclusion in India and the need for enhancing it. Subsequent articles will cover the main aspects of the regulatory regime and introduce some key players as well as models, both domestically and internationally. The domestic models can highlight what we’ve achieved so far, while the international models will demonstrate what we can still learn and apply. 

What is financial inclusion?
The concept of financial inclusion was best summed up by the Rangarajan Committee in 2008 as “the process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost”. 

Universal inclusion has been a policy goal for decades and has witnessed the participation, employing various models, of several players over the years. As a result, India has done quite well in this field relative to its income levels, as shown below. However, as with so many other policy goals over the years, progress is still insufficient and much more needs to be done.


The need for FI
It is by now well known that financial inclusion is an important tool in aiding the development of an economy. Sustaining India’s rapid growth in the future will require the upliftment and participation of its entire population. Small wonder then, that the Indian delegation at the annual meet of the World Economic Forum this year adopted as its theme the phrase “Inclusive growth”. We have managed to jump on to a high growth trajectory, but have not yet ensured the participation of all sections of society. Achieving that confronts us with the challenges of scaling new models while ensuring a high degree of consumer protection. The latter point is particularly important since the target population comprises the economically vulnerable sections.

Unfortunately, despite the focus on the priority sector, banks have been unable to achieve this balance, and have therefore shied away from efforts to promote universal inclusion. The current lack of transaction history that has arisen from availing the services of the informal financial sector means that banks are not able to conduct credit checks on poorer people, and fear higher default rates in case they extend lending to this segment. Additionally, since they earn their revenues from floats (sizes of deposits), their costs of servicing a poorer person’s account (i.e. smaller deposit sizes) frequently exceed their revenues from it. 

Financial inclusion can channel the population into the formal sector and so enable better record-keeping of transactions. Through this, credit history may be monitored, ensuring a more sustainable model of lending/borrowing, so crucial to rural development. With access to formal finance, the rural poor need no longer go to moneylenders that charge exorbitant rates of interest. They also have increased security in financial flows such as remittances and can cut down on time and money costs to streamline the process. The transaction record-keeping will stamp out money laundering and fraud, and so cut into the parallel black markets that eat into the country’s GDP. It would thus also boost tax collections. 

Perhaps most importantly, it would increase uptake of the government’s various social welfare programs such as NREGS, Sarva Shiksha Abhiyan, and Janani Suraksha Yojana. Additionally, since the government is one of the largest bill payers and micro-payers in the country, it stands to benefit a great deal from making all its payments flows electronic. A 2010 McKinsey study titled “Inclusive growth and financial security” found that such automation would lead to savings of about US$ 22.4 billion per year. These efficiencies may be brought about by plugging leakages (diversion of benefits to unintended groups), reducing transaction costs (including time and effort) and administrative costs (such as audits, reconciliations, etc).

At present, the government desires that all the NREGA payments, tens of millions of which are distributed annually, be made electronically via biometric smartcards. This, however, is a money-losing scheme for both banks and their business correspondents due to high rates of dormancy and ‘carding rampages’ to increase penetration. The government offers banks a Rs. 50 subsidy for each card issued, as well as 2% of the throughput as a fee, but this is insufficient for deploying the smartcards and setting up the requisite infrastructure.

In rural areas, people typically use bank accounts to: receive payments from such social welfare schemes, receive remittances, and store their money safely. And banks, typically, do not have an incentive to encourage such financial inclusion for a variety of reasons as listed above. Further, since bank branches are frequently situated far from the target populations, even people have no incentive to travel large distances to transact in any capacity. 
A 2010 IFMR study on remittances (covered later in this article) found that the recipients in its sample spent an average of 40 minutes in traveling and 50 minutes in waiting for their transactions at local bank branches.

This reluctance of banks to serve the financially excluded is illustrated by the graph below, which shows that the per capita number of bank branches is falling in rural areas. In fact, India currently has just one bank branch per 16000 people, a very poor ratio when compared to developed countries such as Japan (one branch per 1960 people) or Germany (a branch per 1480 people), or even to other developing countries such as Brazil (one branch for 9300 people).


The current situation in India 

With the banking model having underperformed so far, we have to look at new and innovative ways of bringing people into the formal financial system. One model that comes to mind now involves using the ubiquitous cell phone, a device that India has adopted in a big way across all sections of society. Using this model to address the needs of society requires a better understanding of these needs.

Deposits vs. cell phones
At present, only 45% of the adults in India have access to a bank account. This figure falls to 27% for rural households with access to any financial services (Economic Survey 2007-08). Further, there is a strong positive correlation between income levels and bank accounts, indicating that richer people are more likely to have a bank account than poorer ones. This correlation transcends the rural/urban divide. According to RBI statistics, 72% of those earning less than Rs. 50,000 a year lack a bank account. With 40% of the Indian households earning less than Rs. 75,000 a year (based on NSSO data), this creates a big challenge for banking coverage. 


On the other hand, India currently has about 730 million phone connections, indicating a tele-density of about 65%, and is adding between 10-15 million connections a month at a CAGR of 45% over the past five years. Using mobile phones as a banking platform would enable anytime log-keeping and would eliminate travel costs.

Remittances: another untapped need
India has about a hundred million domestic migrants, by some estimates, and a 30% urbanization ratio as per a 2007 UN report. These migrants often leave their families in search of better earning prospects, and regularly send their savings home. Latest estimates done by the Centre for Microfinance (IFMR) show a high dependence on informal channels for sending money home. Up to 57% of the respondents reportedly used informal means to remit money to their families, and the primary concerns of these respondents were safety and convenience of the remittance. Since banks don’t have a large extent of rural penetration and impose strict KYC norms, migrants are forced to use more expensive and risky informal channels such as hawala transfers. Indeed, only 30% of the respondents of this study used bank networks to remit money as against 49% who would have preferred to use it. Those using banks tended to have relatively higher incomes, which is unsurprising because of course the proportional costs fall as the transfer amount rises. Of all the transfer methods, the users of cash couriers were the least likely to prefer any other method due to the convenience of doorstep delivery and the relatively inexpensive costs.


India also has a network of a hundred and fifty thousand post offices, far greater than the sixty-five thousand bank branches spread across the country. Many people use this network for remittances, savings accounts, etc, despite the higher costs of transferring money by this method as well as the limited reach of the web based instant money order service (which is available at only a thousand offices due to infrastructure costs).

Not just transactions, also a lack of access to credit
On the other side of the balance sheet, the Third Census of Small Scale industries conducted in 2001-02 showed that while 14% of the registered units enjoyed bank credit, just 3% of the unregistered units had bank loans. 
52% of farm households do not have access to credit, as per NSSO data. Of the remaining 48%, only 27% have access to credit from formal sources. 

Indebtedness is substantially lower amongst the poorest due to a lack of availability of funds for them. Banks are reluctant to lend to this section due to the small loan amounts which are costly to service. Additionally, the debtors have irregular incomes and no transaction history, which means banks are unable to assess their creditworthiness. Their borrowings are therefore principally sourced from the informal sector, largely for purposes of non-productive household consumption, and are unsecured as they have no assets to offer as collateral. Sourcing these borrowings from the informal sector again leads to costly transactions going unrecorded, thus creating a vicious cycle of financial exclusion.

Microfinance emerged as an alternative to the bank-credit system about four decades ago. However, it also suffers from many limitations in the present form. The Self-help group (SHG)–bank linkage program, which is managed by NABARD, is the largest microfinance program in the world with a reach of 54 million. But it is heavily subsidized and focuses only on credit delivery. Similarly, micro-finance institutions (MFIs) serve a large number of borrowers but their penetration has not crossed 3% (World Bank, 2006). This is again due to high transaction costs.
In fact, Andhra Pradesh, which accounts for a quarter of the micro-lending industry, witnessed a recent spate of farmer suicides due to overcharging and coercive recovery methods by MFIs. A subsequent Ordinance issued by the State government to curtail the independence of these MFIs led to loan recoveries plunging to 10-20%, and a consequent halt in fresh lending & ability to service existing clients. This led to the RBI setting up the Malegam Committee to address the problems in the micro-lending sector. The Committee’s report, which came out in January, recommends better regulation of MFIs. It remains to be seen whether any of these recommendations are adopted, and to what extent. However, this issue highlights the need for a coherent, well thought-out policy process to tackle an evidently complex task.

The way forward
Looking at all the alternatives that are being used for financial transactions, reducing costs and raising credit history stand out as paramount concerns.
Electronic banking, made possible due to the introduction of information and communication technologies (ICTs), can prove to be a potent weapon in the battle to increase financial coverage by leapfrogging traditional banking infrastructure. Amongst the various alternatives, mobile banking is seen as the most viable option to enable universal financial inclusion. Allowing financial transactions to be conducted via the mobile phone is a promising idea because of the logistics involved with it. Mobile phones are ubiquitous and don’t require a large amount of physical infrastructure apart from a few telecom towers. They are portable and enable transactions to be carried out anywhere and anytime, with automatic record-keeping.

Amongst ICTs, the setting up of ATMs is also a step in the right direction, as they have lower costs of installation than bank branches, but unless some standardized color coding is introduced for each service rendered, ATMs will not be a useful tool in areas that witness high rates of illiteracy. 
Cards are another form of branchless banking, and credit, debit & cash cards are gaining popularity. Whatever the path, some form of a digital payments system is definitely valuable, from the point of view of focusing on transaction-based activities and cost-effective delivery.


What has been the bank response so far? One way to encourage the spread of banking has been through business correspondents (BCs), which can be a useful alternative or supplement to ICTs, depending on their deployment, and which are a practical solution to the challenge of branchless banking. Allowing banking functions to be outsourced to agents such as kirana stores, petrol pumps, post offices etc would further the cause of financial inclusion as these institutions have better retail and distribution networks and are more likely to be present in isolated rural areas. As many as 8 million accounts had been opened through BCs by 2009, as per a study by N Srinivasan. And now, the RBI has asked banks to extend services to another 72000 villages by 2012.

Of course, there is another change that banks can adopt to encourage financial inclusion, by shifting their revenue model to one that is dependent on transactions and not on account balances. Poorer people, typically engaged in daily wage labour, conduct more frequent financial transactions. These transactions include the savings remitted back to families in the instance of migrant workers. Allowing banks to earn their revenues off these transactions instead of through deposits would compel them to tap into this financially excluded sector. A 2008 RBI study found that 87% of the accounts in a district, which was reportedly 100% financially included, were lying dormant. This was probably because banks limited their use as they lost money on each account with insufficient floats.

However, including cell phones into the grand scheme of things means that banks won’t have to go it alone and can create a symbiosis with telecom firms so as to eliminate the problems stemming from their revenue models. In such a symbiotic relationship, we will witness the emergence of several…

Key players
Many big players can aid in this cause of furthering inclusion, either through their deep pockets, or their extensive retail networks. These players can include internet service providers, payment system operators, technology providers, mobile network operators, banks, retailers, etc. Particularly important will be the roles played by SBI, ICICI, Airtel, Vodafone, Reliance, India Post, Public Call Offices (which has a network of four hundred thousand outlets), NABARD and the UIDAI that is being spearheaded by Nandan Nilekani. Their active involvement will require an enabling regulatory environment. Let us see how this story plays out. 

In the next article in this series, we will cover the existing set of financial sector regulations, particularly in terms of barriers and opportunities, which have an impact on inclusion. The challenge of making regulation meet the needs of the poor will need inputs from many stakeholders; what is important is to create a conducive ecosystem that does just that.