Thoughts & Ideas

Sunday, August 12, 2018

Payment Banks


Payment bank’s seem to be much in news lately for a lot of wrong reasons. Some are questioning their continued viability, especially considering many of those who had shown interest in obtaining payment bank licenses have backed out. Others are questioning the very rationale of their existence / formation in view of seeming never ending violations of license conditions by the existing players. 
To appreciate this very topical and interesting issue, which might soon affect all our lives, one needs to appreciate a little more on how financial intermediaries, such as banks, operate and maintain their viability and profitability.
Bank's around the world are highly leveraged entities working on wafer thin margins and are able to generate profits by resorting to "economies of scope" and at the same time avoiding bad-debt losses. That is, they use the same set of available assets (investment in branches, information systems, people etc) to offer a wide variety of related services, on each of which they make small amounts of money. These services include deposits, loans & advances, money transfer services, payment services, investment advisory along with third party sales of investment products such as mutual funds, insurance etc. Bad debts, inflict a double whammy on banks. First, bank’s lose out on interest income on bad debts thereby depressing their operating profits  and second they have to make provisions out of their operating profits (and if that is insufficient from their Net Worth) on the quantum of bad debts. Incidentally, banks start making operating losses by the time their Gross NPA levels increase a level of 4% to 5%! This makes bad debts anathema for banks.
Payment bank's by definition / as per their licence conditions are precluded or restricted from offering a whole lot of these services, thereby, prima facie, making their operations sub-optimal by default! So would the brave-hearts (and their financial backers) who have ventured out in setting up payment banks eventually lose the shirts of their backs?
Inspite of this congenital draw-back, it was necessary to introduce this innovation in Indian financial markets, since they bring skills and technology which will help (is essential) to bring down transaction costs. Traditional banks not only lack this technology but are by experience / temperament hesitant in adopting it.
The question here is how would bringing down transaction costs, help. Consider a simple Jan Dhan Yojana Account. The government has pushed establishing these accounts and lap-dog banks have fallen all over themselves in fulfilling their quotas of opening such accounts. But then why are there so few operations in these accounts? Why have such a large number of JDY accounts virtually nil balance? The simple answer is because it is very expensive to operate these accounts!
A poor worker would have to lose a day's earning to go to the branch to either deposit / or withdraw funds, or for that matter do any transaction. The time, effort, and money spent in going to do the transaction and the opportunity cost of income foregone in going to the bank are all part of the customer's transactions costs. Similarly, these small value accounts add more to transaction costs of the banks than to their revenue and as rational entities they have no incentive to promote them. Don’t believe me? Try and open a JDY account in any branch, anywhere in India.
Now technology is available which would substantial bring down such transaction costs. Many of us are already benefiting from it. The trick is to take it to the masses. The way the market for shampoos / cell phones exploded in India when 5 rupees sachets and life time free incoming calls was introduced, the same way the banking market is very likely to explode with reduction in banking transaction costs. And this explosion will take the real economy along with it on a sustainable growth path where there would also be no need to cook up GDP figures.
Once the technology base of banks is strengthened and is assimilated, the same set of skills can further transform all the other area of banking operations bringing down overall operating costs of banks even further.
And such innovations, especially those bring about disruptive changes, are rarely brought about by existing players. Hence, Payment Banks, Small Finance Banks et al!
Over time, payment banks have only two options – either being bought out by traditional commercial banks or building up a customer base large enough to enable them buy out one of the existing banks. I expect that soon, very soon, they will have plenty of such options available. I don’t expect them to lose money or investors who have put their money in their equity to lose their shirts!
Yes, there are and will continue to be hiccups.  But wouldn’t life be extremely flat with nothing whatsoever to grumble at!

Monday, June 25, 2018

NPAs – Isn’t Prevention better than Cure!


The large and increasing levels of Non Performing Assets of the Indian banking industry has been hogging headlines for quite some time now, and there seems to be no end to the saga. To manage and contain this problem academicians, policy makers, RBI, and the Government have come up with various solutions with the insolvency code being the latest kid in the block. 

The proximate reasons for phenomenal increase in reported non-performing assets (NPAs) over the last three years, is not change in economic conditions or wilful defaults. It is simply because we had a strong regulator who insisted that banks follow the laid down, internationally accepted norms for recognizing NPAs – the so called Asset Quality Review. Otherwise, it would have been business as usual till one fine day the banking system would have simply collapsed and taken the real economy (and all of us too) along with it!

Any solution to a problem needs to first look at the reasons as to why the problem has arisen. Let us do the same for our “NPA” problem!

A manufacturing organisation makes physical products – say cars, or detergent, or steel utensils etc. To ensure consistent production of goods of high or at least acceptable quality they set up quality control systems which encompass design of appropriate manufacturing processes, quality control of their raw material or sub-assembly suppliers, correct operation and control at each stage of the manufacturing process till production of the finished product. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

Similarly, one of the key functions of banks is to continuously produce good quality loans & advances. By good quality, it means loans which are remunerative and have low probability of default. From this perspective, the incidence of high and growing levels of NPAs in the Indian banking system is akin to a manufacturing organisation making a larger than acceptable level of defective products.

The production process used by banks to ensure that consistently good quality loans are made consists of making a series of appropriate judgments or decisions for which banks need to have, inter alia, an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and suitable training, understanding how or why credit risks arise and having clear laid down credit risk  management policy, having a suit of loan products which are in line with the requirements of the potential borrowers and the risk capabilities of the bank, a not too cumbersome loan documentation process (this is extremely tricky since workable debt contracts are far from complete contracts!), monitoring the loans once it is made, and taking corrective action as and when required, entrapping the cash flows etc. All these taken together would ensure a high probability that the loans & advances made are repaid on time and on the terms agreed at the outset.  Failing which, banks have to have sound processes for recovering loans which go bad inspite of taking all possible measures earlier.

Now for banks to be able to take sound decisions it is essential to create a governance framework which encourages and nurtures independence and professionalism. Something which is just not engendered by having RBI, GOI, vigilance departments, criminal investigations, and courts micro-managing how banks perform their work and breathing down the necks of bankers 24 by 7. One result of such micro-management is the extremely voluminous loan appraisal notes prepared by banks. This detracts focus on the nature, quality and key risks of the credit while protecting all the people involved in the decision making process from any adverse outcome. The consequence is extreme delays in decision making and no clear cut indicators on accountability. In practice, ultimately the most helpless lowest level official, who has no support of the union or political support of any kind who ends up facing the music. This in turns leads to decisions being based on all kinds of extraneous reasoning which have little to do with the borrower and the credit risk. Appraisal notes running into 100 – 150 pages is the norm. I really wonder as to what kind of reasoned decision taking can take place under such circumstances. 

I would like to give another small (and totally unrelated to present discussion on NPA management) example of micro-management by RBI. For anyone doing any kind of business, the base level understanding is that they should know their customer. Even a doctor evaluates his patients on parameters others than strictly medical, say on socio-economic parameters, before prescribing any line of treatment. Now banks have to follow a strict and detailed KYC norms prescribed by RBI (which is also extremely difficult to comprehend). Are our banks and bankers so incompetent that they are unable to properly and correctly evaluate their customer?

Having nearly 70% of our banking system in the public sector has had another extremely adverse effect – the virtually complete absence of creativity and innovation. The closed, one size fits all framework for recruitment, promotions, pay-scales, to the extremely outdated and dysfunctional conceptual system under which most lending and monitoring is done, and the identical Core Banking System has left little room for experimentation and innovation, or growth. After all only open systems can hope to achieve negative entropy! Public sector does not automatically mean lack of professionalism and accountability, provided governance systems enable and nurture it. In this regard the continued interference of DOB, MOF with its natural consequence of politicization of decision making at all levels is a key factor and needs to be addressed forthwith. Any change for the better would have to start from here.

On the conceptual framework of lending in India, a couple of issues are extremely critical. First, the dichotomy on working capital versus term lending is not only artificial but also misleading. For the lender there should be only one focus, the debt servicing ability (both quantum as well as volatility) of the borrower and mechanisms for entrapping cash flows. No borrower can service its debt (which is the same as no lender can expect recovery) by recourse of foreclosing just either the working capital assets or the long term assets – or even both. For debt to be serviced the sine quo non, which is invariably missed out, is a functional borrower which can be expected to continue indefinitely as a going concern and create economic surpluses. Second, the single minded focus on security in lending misses on the nature of risk – whether the risk being assumed is in the nature of a debt risk or an equity risk – resulting in mispricing of the risk. An experience through which all of us have lived for more than 30 years are our DFIs. They were taking exposures on a portfolio of assets where their risk was essentially equity / quasi-equity in nature while their returns were wholly debt related. It is natural that the returns from such a portfolio would be sub-optimal. The main culprit here was equity risk premium, not sloppy appraisal or monitoring or the biggest bug-bear of all of us – corruption.       

The idea of having a “bad bank” is very much workable, if and only if, the reasons for proclivity of Indian banks to continuously create NPAs is first sorted out. The capital requirements can be fairly easily be met even for transferring entire reported NPA level of Rs.10 lakh crores. First, the bad bank need not take over the entire NPAs at book value. They can very well take it at a discount of say 10% of the book value with agreement to share any surpluses in recovery over a certain minimum. That would reduce the total capital requirement to Rs.1 lakh crore. Second, banks typically function at a Capital Adequacy Level of about 12%. As such the equity required to fund holding Rs.1 lakh crores of assets would only be around Rs.12,000 crores, with the balance funded through debt. This equity be funded on 50:50 ratio with GOI picking up Rs.6000 crores and the banking industry taking over the balance Rs.6000 crores. The balance capital requirement could be met through debt from the banking industry itself specially if such debt were guaranteed by GOI and qualify as SLR investment.

Keeping NPAs low for banks is critical for various reasons. First, NPAs deliver a double whammy to the bottom line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. Second, banks being highly leveraged entities have much lower room to manoeuvre fall in operating margins, something rising NPAs result in. As such, it is important that actual NPA levels be monitored regularly and closely, otherwise they start making losses. Third, by affecting ability of banks to provide loans as well as liquidity services to the real economy (since the quantum of lending / funds available to grease the economic system with banks is exponentially inversely proportional to rising NPA levels) the income and employment opportunities in the real economy start getting curtailed (rather drastically) with rising NPAs in the banking industry. Finally, banks maintain the institutional memory of credit history of all the actors in the real economy in their records. It is very hard and expensive to recreate this information once lost. When NPAs become so high that a bank becomes bankrupt and has to be closed down, this memory is as good as lost forever. This in turn leads to a break in the payment cycle to and from the various players in the real economy, which in turn hits the real economy hard by drastically reducing both income and employment opportunities in the economy. These are the primary reasons that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones and making managing NPA critical for our collective well-being.

Monday, June 18, 2018

On the Functioning of Financial Markets


The article, “The Jan DhanYojana, four years later” in The Hindu dated 29th May 2018  though topical, and containing a few hard facts and figures, does not do justice to this very important subject and is way off in some of its conclusions. I will try and justify my contentions in this monograph. Please have a little patience.

Financial Inclusion is not just about opening bank accounts, using these accounts, and providing access to formal credit. To appreciate the importance of the concept of Financial Inclusion one needs to step back and see why and how strong, stable, and inclusive financial systems (banks and other financial intermediaries, finance companies, cooperative credit societies, capital market institutions etc. along with a strong regulatory framework) are essential for steady, accelerated, and equitable economic growth.  There is extensive literature on the subject starting from the 1960s, especially seminal ideas propounded by Gurley, Shaw, McKinnon et al. 

Naturally, for an inclusive financial system, all or most citizens need to be involved and be part of it. For example, people need to be able to ride the Bullet Train if they are to benefit from it. Just watching it whizzing past is not going to be of much help to either the people who built the Bullet Train, those who operate it, or the general public!

Developed and well-functioning financial systems, inter alia, (a) enable users to reduce the cost of exchanging real resources ie, through elimination of rigidities and reduction in transaction costs through both economies of scale and scope and use of technology by the financial intermediary; (b) leading to more efficient resource allocation, (c) provide the backbone of the payment mechanism, (d) helping to distribute and reduce risk for users (through tenor transformation, portfolio diversification, better monitoring through specialized skills etc), (e) enable easier accumulation of short & long term surpluses, (f) balance savings with need of funds over lifetime changes etc.  

Now starting with saving mechanisms, for any user of financial savings product (such as a JDY account) it should be safe, convenient, reliable, and cost effective. If a person has to spend half a day (that may mean losing a full day's earnings) to go to the bank to deposit or withdraw money he or she would obviously not use the facility. Add to that the paperwork in opening and operating the account. Or the transaction costs for small value receipts / payments using app-based software.  From the bank's point of view, transaction costs for servicing small accounts tend to be rather high and are naturally neglected - it just does not make commercial sense. Furthermore, if there aren’t steady and regular interactions between the intermediary and its customers, no trust based relationship can be built up leading to its eventual atrophy. 

The authors mention that 48% of bank holders have not done a single transaction during the past one year. This statistic by in itself hides the fact that there are have been reports of bankers putting in paltry sums of Rs.1 to Rs.10 in JDY accounts to show some transactions and lower number of zero balance accounts!1

As far as penetration of JDY accounts are concerned, the statistic that 80% of adults having bank accounts level mentioned in the article may need some scrutiny since the thrust of JDY is that all families should have functional bank accounts and the focus is not on individuals.

It also does not bring out the urgent need and pent up demand for savings mechanisms for small savers. In a study conducted by Stuart Rutherford2,  he discusses the service provided by Jyothi, a middle-aged semi-educated woman who makes her living as a peripatetic deposit collector in Vijayawada, whose clients are slum dwellers, mostly women. Jyothi has, over the years, built a good reputation as a safe pair of hands which could be trusted to take care of the savings of her clients. Jyothi’s accepted deposits of Rs.5/- every day so as to collect Rs.1100/- over 220 days. After which she returned Rs.1000/- to the depositor and retained Rs.100/- for her services. This translates to an annual negative interest rate of 30% per annum for rendering deposit services! Which I suppose is more than sufficient to make all our academics, policy makers, bureaucrats, politicians to start shouting Bharat Mata Ki Jai / Holy Marx / Jai Bhim or whatever and jump all over the place. But the fact remains that savers are willingly paying that kind of money since they value that service which the formal financial systems has failed to provide. Rutherford goes on to mention that slum dwellers in a neighbouring slum where there is no Jyothi at work actually envied Jyothi’s clients. Service providers for savings take different forms in our slums, villages, hamlets such as chit funds (formal & informal), Self Help Groups, and the numerous multi-level marketing companies which keep springing up from time to time all over the country.

All this springs from failure of our organized formal financial systems to provide such a service. The sad part is that this was not always so. Commercial bank’s did offer variations of something called Pygmy Deposits where deposit collectors made daily / weekly visits to collect the small savings and they provided this service without incurring a loss! For example, see the experience of Syndicate Bank discussed in Financial Innovations and Credit Market Evolution by V V Bhatt (EPW, Vol XXII, No 22, May 30, 1987). These were the days when banking operations were fully manual and as such the benefit of much lower marginal operating costs through use of digital technology was not available.

The thrust on promoting savings also does not take into account another critical aberration in our financial systems. Namely, due to widespread financial repression financial savings in formal institutions give a negative return in real terms! In this context, it is worth quoting the erstwhile Governor of RBI3 has gone on record in his speech wherein he mentioned that, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”! Does that indicate as to why our society is subject to repeated onslaughts of Ponzi schemes all of which eventually and inevitably collapse. But during the course of their short existence promise an avenue for building up liquid financial saving which does not give negative returns in real terms.   And I am not even hinting on the effect of TDS on bank deposits which is extracted with clinical efficiency thanks to the superlative strength of Core Banking Systems.

Now let us see what happens in the absence of formal mechanisms for collecting small savings. They would have to be saved in kind since saving in cash would entail it losing value over time due to inflation if it was not lost, stolen, or borrowed away. If the saver managed to evade all these possibilities there is always the chance of it being spent on gambling or liquor. Saving in kind also has the added disadvantage of lacking fungibility and liquidity (the characteristics which gives fiat money its intrinsic value).

There also seems that there is another major and deep-seated myth among our academics and policy makers  -  that the poor do not and cannot have savings, or at least substantial savings. They need to appreciate that since earnings are highly variable and uncertain for the poor and they have absolutely no social security of any kind, savings are critical for survival. The small bits of savings is what enables the poor to survive from one misfortune to another. These savings take various interesting forms (again due to the failure of formal financial markets), such as, having reciprocal borrowing arrangements with friends and relatives, maintaining credit reserves with whom they provide services and products (by not immediately drawing down payments which are due), social practices such as neota, maintaining excess reserves of food grains and other items of inventory, keeping a few heads of goats, pigs, chicken etc which could either be sold or consumed as per dictates of circumstances etc.

This myth is also directly responsible for lack of attempts to design better savings mechanisms and for the stress on provision of credit as the proverbial magic wand for solving issues of “financial inclusion”.

Savers using the services of formal financial institutions like banks are cursed once again in another way. Since our bank’s are not making sufficient profits on the lending side of their business, they are naturally unwilling and unable to provide higher rates of returns on savings, especially in real terms! This suggests that the inefficiencies of the banking system and the borrowings from the formal financial sector are being subsidized by the deposit keeping community at large.

Now if one were to argue for promoting savings since it makes social sense,  one could also seek that the government should subsidize some portion of the operating costs – maybe through a reverse auction kind of mechanism. Banks could compete for achieving lowest cost for providing particular desired services, with the subsidy levels being based on this level. Since this subsidy would benefit society at large there would be much less scope for corruption. Otherwise banks will (and are becoming) become sick. Policies and practices which make banks sick will ultimately be of no good to either its customers or the economy. Continued good health of banks is essential for the real economy to remain robust - the reason they are so heavily regulated. Sick banks which have to be closed down also result in loss of institutional memory of the credit history of society, something which is impossible to recreate. For social and economic systems it is equivalent to heart failure in humans.

Technology may help in reducing transactions costs. Unfortunately, the system which has evolved over the last 30-40 years has resulted in traditional (PSU) banks lacking the requisite technical skills. Even worse, the one size fits all policy with industry wide equality in pay-scales, service conditions, internal processes, even the Core Banking System that they use, has stifled creativity and innovation. Something which is essential for growth of a vibrant financial system. An argument often given is that bank nationalization has enabled large increases in financial savings in the economy with its resultant positive effect on capital accumulation and economic growth. However, no one bothers to think about the cost of such savings mobilization – could the same levels of savings have been mobilized in more efficient ways, ie at lower costs?

The new generation pvt sector banks and the newest chips of the block - payment banks / small finance banks - either have too little incentives to pursue these market niches or are circumscribed by definition from benefiting from economies of scope, respectively!

Now coming to the stress laid on provision on easy access to credit, one needs to first appreciate that the ability or temperament to productively use credit is not very widely prevalent in any society. As such only a limited number of persons or families can benefit from access to credit. Furthermore, additional credit, cheap or costly, is no substitute for functional roads, primary health and education facilities, organized markets, or an administrative machinery which can prevent exploitative relationships. Even worse, there are well documented severe negative consequences in following a credit focused financial inclusion development strategy which include:

a)   Increasing levels of inequality in income and wealth since directed credit is cornered by the wealthy and politically powerful who thereby increase the capital at their disposal and become even more wealthy and powerful.  Larger loans means larger benefits, smaller loans means smaller benefits, and no loans means no benefits as far as the borrowers are concerned. And bulk of the people lie in the third category.

b)  Incentive to repay by borrowers who have preempted credit (typically through muscle or political power) is lower which not only further increases their economic and political status but simultaneously weakens the financial intermediaries who have lent the funds and have to book the consequent losses.

c)    Development of large and widespread corruption since the benefits are concentrated while the pain is widely spread, there is little focus or effort at tackling the resultant problems. Is it a wonder as to why our cooperative credit system produces some of our most corrupt politicians?

Another issue which hardly ever gets raised is the cost of capital. Interest rates reflect the cost of capital and it is well known that in India there is a very wide difference in the interest rates charged by most formal financial institutions / banks versus those charged by the fairly well organized informal institutions. The question that next arises is whether the informal sector is charging excessive rates or is the formal sector mis-pricing cost of capital.

Well interest rates in the informal markets are, prima facie, higher than formal markets. But would they still be considered higher cost after accounting for delays, the numerous trips, and the bribes with their associated real, direct and opportunity costs involved in accessing formal credit? The higher interest rates in informal markets also reflect the fact that (a) they are taking exposure to much higher risk levels, (b) provide kinds of services (other than credit) that formal intermediaries cannot even dream of, (c) have much less capital at their disposal as such require to charge higher rates to generate equivalent absolute amounts of return, (d) entire capital is in form of personal equity as such do not benefit from leverage (banks with Capital Adequacy Ratio of say 10% effectively have a leverage of  10:1) with its consequent benefits, and (e) during the slack season their capital is idle and does not generate any returns or meager returns.

Total cost of credit consists of basically two components, a fixed cost of accessing the credit which varies little with quantum of credit and a variable component, the actual interest rate. As such, for small value loans the average cost can be quite high since the fixed component has to be recovered from a smaller principal amount. This is another reason as to why informal lenders score over formal lenders, especially for small value loans and continue to be relevant. In this regard, Jerry R Ladman4 argues that “The partitioning of the market between BAB (a formal lender) and moneylenders shows the two lenders are providing different services. The moneylender provides credit quickly, on short-term basis, and in relatively small amount.”

Incidentally, the All India Rural Credit Survey (1951) (considered the gold plate for study of rural credit world-wide) does not support the prevalence of widespread use of exorbitant levels of interest rates commonly alleged to prevail in India! Data in this Survey indicated that village moneylenders grossed only an average of 11 percent per annum on their lending5!

Formal studies6 also suggest that the higher interest rates charged by the informal sector can be largely attributed to risks and administrative costs and not to monopoly power

Considering these factors, the conclusion arrived by most mainstream policy makers and the impression generally carried by most of us that informal money lenders are blood sucking thieves and rogues of the highest order seems not really substantiated by facts and logic. The reader may also care to remember that interest rates charged by many formal sector entities such as credit card companies and FinTecs involved in lending are not exactly cheap and more akin to rates charged by the informal sector.

Before concluding I would like to share a few quotes attributed to the ever-provocative Dale Adams, (Emeritus Professor of the Ohio State Rural Finance Program):

a)      "It is curious that the discomforts caused by a few people going into debt and not being able to repay tend to dominate general views held about financial intermediaries. The use of extreme cases to make general points is refined to an advanced art form in discussions about financial markets. Stories about poor farmers who lose their land to evil moneylenders are retold until people think that most loans go to default ….". (from Effects of Finance on Rural Development in Undermining Rural Development with Cheap Credit)

b)      … lenders provide loans, not gifts, and this creates obligations. When misfortunes strike, those obligations cannot always be met, putting the borrower into even greater jeopardy (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

c)       … to the unwashed it (empowerment) conveys the impression that smearing a dab of additional debt on a poor woman will transform her into Super Woman. Those who insist on using this bloated term grossly overstate the contribution that indebting crusades play in easing poverty. More debt does not cure malaria or HIV/AIDS. It does not provide clean drinking water or prevent flooding. It does not improve law-and-order or eliminate weeds in a borrower’s crops. It does not make crops grow in barren soil or provide secure title to land that squatters occupy. It does not provide schools or teachers for the poor . . . (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

There is much room for change / improvement in policy framework to enable our banks deliver on their capabilities. But such change should be based on an understanding of the nuances of functioning of financial markets and their main players such as banks. Propounding old, half-baked, hackneyed theories is not the way out – it is getting us into deeper mess.

1.   Government claims Jan Dhan Yojana was a big success. Here’s a reality check by Mayank Jain, The Scroll, 6th September 2017;  & Jan Dhan Yojana: One Rupee Balance and the Dormancy-Duplication Problem by Anuj Srivas, The Wire, 14/09/2017.
2.     The Poor & their Money, Stuart Rutherford, Oxford India Paperbacks
3.    Policy & Evidence.  Inaugural Address by Dr. Raghuram Rajan, Governor, Reserve Bank of India at the 10th Statistics Day Conference 2016, Reserve Bank of India on July 26, 2016, Mumbai 
4.    Ladman, Jerry R. Loan-Transaction Costs, Credit Rationing, and Market Structure: The Case of Bolivia, in Undermining Rural Development with Cheap Credit.
5.   All-India Rural Credit Survey, Vol. 1, The Survey Report, pt. 2, Bombay, Reserve Bank of India, 1957, pp. 490-91. - quoted by David H Penny in Rural Financial Markets in Developing Countries, page 66.
6.   Bottomley, Anthony. Interest Rate Determination in Underdeveloped Rural Areas, American Journal of Agricultural Economics 1975;
7.  Long, Millard F. Interest Rates and the Structure of Agricultural Credit Markets, Oxford Economic Papers 1968.

Sunday, April 15, 2018

On the Importance of Universal Primary Education


Yesterday, 14th April 2018, happened to be Babasaheb’s birth anniversary and coincidentally Ananya Vajpeyi, a scholar specializing in Ambedkarite thought, was in Hyderabad to deliver a talk at the invitation of Manthan which I was fortunate to attend. The focus of her talk, was the ideas and vision of Ambedkar and its relevance to present day India. She specifically stressed on the primary importance Ambedkar gave to education.

Ms. Vajpeyi’s expounded on a lot of issues in her talk, a couple of which I have been trying to logically sort out. For example, she spoke of the need of preserving space for youngsters from different sections of Indian society in terms of caste, and gender, and economic background to meet, discuss, debate, interact, and disagree and how Universities provide just that. She spoke on the threat being faced in maintaining that space, especially after the coming in power of the present political dispensation. She also stressed on the contribution our Universities and Institutions of higher learning and research make to the development of knowledge and skills. I am in complete agreement with her, but I am still troubled.

Basic economic texts describe how all societies need to prioritize their requirements. In classic text book terms, societies need to decide on the trade-off between guns and butter. One can’t have more of both on the given production possibility frontier. In our case let us consider the trade-off between primary education and higher education (including University education). Given our limited resources we obviously cannot have more of both to the extent we desire. We have to choose between the two, not wholly, but of course to a large extent. That is, what would give our society a bigger bang for the buck – institutions of higher education or primary schools?

Let us look at the spin-off benefits of both.

It is well established that better and widespread universal primary education leads to faster economic growth with equitable development. This happens, inter alia, since the quality of economic effort improves with a better educated work force. In other words, human capital developed through prioritizing primary education is essential for sustained and rapid long term growth. This is also apparent from the growth experience over the last 30-40 years of China, South Korea, Taiwan, Thailand, HongKong, and Singapore. All these countries invested heavily in universal primary education over the period starting from the 1950s. A similar process took place in Europe and North America from the mid 19th century onwards.

Apart from helping achieve higher rates of economic development, universal primary education which includes female literacy helps in controlling and stabilizing population growth. In Iran following the “Islamic” revolution in 1979, a generation of girls entered the schooling system and the boom in female literacy translated in the total fertility rate coming down from a level of 6.7 in 1980 to just 2.6 in 2000. A similar negative correlation is seen between female literacy (which can only ever be part of universal primary education) and population growth rates in the States of Kerala, Tamil Nadu, and Himachal Pradesh.

Focus on universal primary education, apart from faster economic growth, leads to more even income and wealth distribution and consequently a more equitable society. This in turn results in lower levels of social dissatisfaction and lower crime rates.

Stress on primary education would also lead to creation of a much larger space for many more young people to meet, discuss, debate, interact, and disagree with its consequent enriching social experience than what would be provided by the universities and colleges.

On the other hand the continued excessive stress on higher education, without development of adequate economic base through universal primary education, leads to lack of sufficient amount of work opportunity which our graduates, post-graduates, and PhDs (rightly) think they are fit for and deserve. Leaving a large proportion of such educated young people (Hobson’s) choice between migrating to developed countries (effectively capital drain from India to developed countries), accepting jobs for which they are over-qualified and which does not give them either the expected levels of remuneration or satisfaction, or remaining unemployed.

Ms. Vajpeyi in stressing the importance of higher education gave the example of present day China which is making concerted efforts to attract overseas highly educated and qualified Chinese expatriates to return to teach and do research in Chinese Universities at world class salaries. But I hope that Ms. Vajpeyi recognises that to achieve this level the Chinese government and society worked over the last 50 years plus in developing their basic primary education (and health care) systems, without which they would never have been in a position to expand their institutions of higher learning.

I agree that one cannot make something strong, by making something else weak. So our focus as a society should not be to weaken the existing structure of higher education, but in terms of priority it is a “no brainer” that the main focus should be on strengthening the universal primary educational system rather than on institutions of higher learning. I think, Babasaheb would have agreed to this proposition.



Thursday, February 15, 2018

Financial Inclusion Revisited *


The Road to Hell is Paved with Good Intentions!

The popular discourse on financial inclusion in India is heavily dominated, in official as well as popular circles, in favour of cheap and directed credit as the preferred or virtually the sole means of achieving quick and easy poverty alleviation with all round economic development, accompanied with social justice. Notwithstanding the fact that additional credit, cheap or costly, is no substitute for functional roads, primary health and education facilities, organized markets, or an administrative machinery which can prevent exploitative relationships.

The near exclusive identification on providing cheap and directed credit with financial inclusion is inspite of extensive literature (both theoretical  as well as empirical) from across the globe that such a policy has severe negative consequences for the economy and society. The initial findings on this line of thought started emerging by mid to late 1960s, and was well established by mid 1980s. Moreover this was not a case of one-off or isolated diversion from main line economic thinking, but is based on research by a number of economists in over two dozen countries and its implementation had all round positive results for countries which implemented such policies, especially South Korea and Taiwan. The irony is that the group of economists who spearheaded this alternative approach had at least one RBI stalwart (Dr. V V Bhatt), though RBI or GOI still barely acknowledge it!

The main negative consequences in following a credit focused financial inclusion development strategy include:
  • Increasing levels of inequality in income and wealth since cheap directed credit is cornered by the wealthy and politically powerful who thereby increase the capital at their disposal and become even more wealthy and powerful.
  • Incentive to repay by borrowers who have preempted cheap credit is lower which not only further increases their economic and political status but simultaneously weakens the financial intermediaries who have lent the funds and have to book the consequent losses.
  • Development of large and widespread corruption since the benefits are concentrated while the pain is widely spread, there is little focus or effort at tackling the resultant problems. It is little wonder that our cooperative credit system has never been able to deliver on its potential and why it produces some of our most corrupt politicians.
  • Progressive weakening of financial intermediaries. Since financial intermediaries are typically highly leveraged institutions with low capacity to handle negative trends in operational cash flows, they try and stabilize their operations and shore up their income through economies of scope. That is offering a wide variety of services using a common infrastructure, thereby spreading their risks and fixed costs over a larger number of activities. Weak financial intermediaries are unable to fulfill their obligations by offering a wide variety of financial products and services and also in terms of mobilization and allocation of capital, and transformation and distribution of risk in society.
The focus on lending being the main purpose of banks leads to neglect of their other essential functions, especially providing safe, convenient, reliable, and cheap savings products which simultaneously provides positive rates of returns to the depositor, and managing the economy’s payment system infrastructure.

Lack of good savings mechanisms leads to a wide variety of negative repercussions, such as:
  • Economy and society is not able to garner its full potential of savings which leads to lower levels of investment and growth.
  • Lack of adequate domestic savings promotes dependence on imported capital.
  • Savings which are not kept securely (say with a financial intermediary) but away from the savers tends to be dissipated through frivolous expenditure (gambling / drinking), borrowed away by friends and relative, lost or destroyed (physically), stolen, and moreover loses value over time due to inflation.
  • Since risk aversion and saving for the proverbial rainy day is an universal human value, lack of provision of safe, convenient, reliable, cheap savings products by the formal banking system leads domestic household savings to be either parked in unremunerative and unproductive capital such as gold / build-up of inventory or in highly risky Ponzi schemes which promise (howsoever ephemeral) positive rates of returns. This suggests a rational explanation as to why our society is subject to frequent instances of various Ponzi like schemes with steady regularity. 
  • The focus on parking savings in gold is especially attractive in view of its relative liquidity and as a hedge in value. However this in turn generates huge demand for import of gold with its consequent negative impact on the country’s balance of payments / deficit in current account.
Bringing savings into focus as the prime instrumentality of financial inclusion is not a luxury we can afford to ignore any longer. This can only be done if our people have faith in banks as safe and stable institutions that provide services at reasonable cost. The strategy for developing stable banks should be to ensure that the users (ie the common man) develop a stake in their continued well-being. This can only be done by increasing the levels and kinds of interactions they have with their banks say by having banks offer a wide variety of related services which are convenient and safe. Moreover, promotion of smaller banks with local staff would also promote reduction in social distance between customers and bank staff. Banks could take a leaf from the book of mobile phone companies – no special literacy lessons had to be imparted to users to help them understand its utility inspite of complexity in usage.

Managing the payment systems in terms of building innovative, cost effective means of universally available funds transfer mechanisms is another story all together. We have a superb infrastructure in place, but it is thanks not to banks (who should have taken the lead) but to RBI and now the mobile phone companies and specialized payment banks. Banks due to their continued insistence on sourcing all skills in-house lack the knowledge of cutting edge technology which enables a wide variety of services in this area. Setting up payment banks might provide some relief, though their continued viability is doubtful since they have limited economies of scope. At the most they can aim for is building up dedicated customer volumes and selling out to established banks. 

The bottom line for ensuring focus on good savings products, innovative payment products, and also reliable credit is to have extensive competition in the banking space supplemented and supported with strict and comprehensive regulation. Extensive and intense competition is the only way to promote innovative approaches to provide financial services. This can be ensured through denationalization of PSU banks, ban on a cartels such as IBA, complete removal of directed credit (in any form), increasing interest rates on deposits, and downsizing the Department of Banking Supervision (it should be made irrelevant). Increasing interest rates on deposits would imply simultaneous increase in lending rates – something which is contra-intuitive and politically very sensitive. However, there is no alternative to developing stable, supportive, non-fragmented financial systems.

It is only through competition that financial innovations may be engendered which would tend to reduce transaction costs and risk, and as a result bring about the widening, deepening, and integration of financial markets. Such financial development accelerates the pace of economic development through its favorable impact on savings, investment, and output.

* Please also see my blog On Financial Inclusion

Monday, September 05, 2016

Are High Interest Rates a Primary Reason for Retarded Flow of Bank Credit?



The Hindu dated 29th August 2016 reports, "Banks unaware of SME issues,says Nirmala Sitharaman”. It reports that our Honourable Commerce Minister is of the opinion that (1) our banks haven’t been understanding enough of SMEs, and (2) High interest rates for long. The article goes on to elaborate that the Honourable Minister feels that interest rates in India are too high which in turn is effecting adequate flow of credit to MSMEs. 

Mrs. Sitharaman seems to be as confused about the issues as the banks that she is criticizing. Well I agree with her that banks in India have little understanding of credit risk which retards flow of credit not just to the SMEs but across all segments of the economy - retail, agriculture, large corporate – you name it. This is reflected not only in the myriad problems faced by potential borrowers, but also in other phenomenon, such as high NPA levels, propensity to invest large amounts in Government securities (more than the minimum required, even though returns are low - at least the harried bankers cannot be accused of improprieties in lending decision – the safety of capital is ephemeral) etc. But laying the blame on high interest rates does not give the correct or appropriate perspective, and such misplaced reasoning hides the real reasons for various imperfections plaguing our banking system, which in turn prevents optimum solutions to emerge.

For a growing economy like India, availability of adequate and timely credit is more important than cost. However, subsidizing credit costs leads to various unhealthy (and unintended) consequences. First, since the subsidized credit cannot be catered to everybody it starts getting rationed, inter alia, through muscle and political power – the first step in ever increasing spirals of corruption. Second, once access to scarce credit is not on merits but through use of power, the incentive to service it (that is, repay the loans) is so much lower!  Third, since muscle and political power plays a largish role in access to credit, it is the larger and bigger social constituencies who corner the bulk of the credit. This in turn leads to higher & growing levels of income and wealth inequality in the country.  Related to this is that, not only the more powerful are able to preempt scarce credit and as such further improve their economic (and social) hegemony, since there is lower pressures on them to repay the loans they get double the benefit. Initially from getting access to credit and having larger capital at their disposal and subsequently by not having to pay for it! As is said in Hindi “dono haath mein laddoo”! 

The adverse effects of artificially lower interest rates on credit goes on to corrode the viability of our financial system in other ways. To be able to lend money, any financial intermediary has to first have access to funds to lend. These funds come from the savings of the society. Now to be able to keep lending rates low, financial intermediaries have to keep interest rates on deposits low to ensure sufficient cushion for themselves to survive. The fact the nominal interest rates on bank deposits, on the average, do not even cover inflation rates is brutally brought out by statement of Dr. Raghuram Rajan in his speech titled Policy & Evidence at the 10th Statistics Day Conference 2016, Reserve Bank of India held on July 26, 2016, wherein he stated, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”.   The result is that millions of poor people lack mechanisms for storing their savings which is not just secure but also provides a hedge on inflation!  As is well said – the road to hell is paved with good intentions!

This unhealthy cycle is best illustrated in our cooperative credit system which has failed to live up to its potential (inspite of various studies and interventions so as to revitalize it) essentially due to extensive political interference and corruption led by subsidization of credit. Even though the nominal rates of interest on cooperative credit may not be directly subsidized, the fact that the State Governments have year after year kept on underwriting the losses of the cooperative credit societies and are expected to continue to do so, provides enough perverse incentives to politicians of all hues to seek continuation of this vicious cycle. Is it any wonder that the cooperative credit system in India produces the most corrupt politicians?

This lack of understanding as to what constitutes credit risk and how to manage it, is reflected in the ever increasing procedures, prolonged delays in approval, all kinds of impractical terms of approval, demand for collateral security, specialized techno-economic feasibility studies, audited financials and of course Credit Approval Notes which resemble PhD thesis and not a tool for arriving at a rational credit decision! Bankers try desperately to hide themselves behind such smoke-screen since they do not know better, but it is of little avail. The entire burden of mush misfeasance eventually falls on us in terms of slower economic growth and an increasingly unequal society manifested in increasing crime and social dislocation.

The workings of the financial system are subtle and diffuse, but its effects are profound and direct on the real economy. There is need for more careful and deeper understanding of its functioning in the design and construction of a vibrant financial system which would lead to a better India. Just blaming high interest rates is simply playing passing the buck.


Tuesday, July 19, 2016

Appreciating Micro-Finance




The Hindu dated 20th July 2016 published a news article titledDue diligence by MFIs vital”, while reporting on the National Summit on Microfinance organised by Assocham in Hyderabad. While due diligence in any borrowing / lending situation is essential, the way MFIs go about doing this, which is much in variance to the practices followed by regular banks, is what makes them special. Not only are the practices developed and followed by MFIs different, they are cheaper and more effective. Let us see how this happens. 

In any borrowing / lending situation, if the lender (reasonably) expects the borrower to repay principal along with interest, the lender has to assess the ability and the intention of borrower to repay.  After the funds have been lent, the lender has to monitor the continued ability of the borrower to repay. Even with the best and most detailed appraisals / due diligence and other precautionary measures including insistence of collateral security, it is not necessary that the borrower would be in a position to repay the borrowed funds. And this is not because borrowers are inherently dishonest (in fact most borrowers are quite honest – at least more than the average banker).  The future is uncertain and circumstances change due to weather patterns, change in tastes, government policies etc. which often creates genuine difficulties in making repayments as per agreed terms.

Assessing the ability and the intention of borrower to repay and continued monitoring of loans is a costly and time consuming exercise (known as transaction costs). Moreover, where the loan size is small, the transaction costs as a proportion of loan size increases exponentially making small loans costly and unremunerative for regular banks.

Micro-finance seeks to solve this problem of high transaction costs by some innovative, by now well established techniques, which virtually does away from having the lender to do detailed (and costly) loan evaluations and monitoring. Some of these techniques include:

a)   Group lending: Small closed knit groups have a quality whereby the borrowers know each other well. So lending to groups who have self- selected themselves ensures that the group does both the appraisal and monitoring. Peer group pressure replaces due diligence by banks.
b)   Loan repayments aligned to the cash flows of the borrower rather than convenience of the lender, say through daily or weekly collections.
c)  Reducing costs to borrowers in terms of ease and reduced costs of transactions through standardized minimal paperwork, centralized collection points which is more convenient to borrowers, doing away with bribes or middlemen etc.
d)   Doing away with the distinction of loans for productive purposes vs consumer loans. One of the most interesting and useful characteristics of money is its fungibility (its raison d’etre). That is, command over money enables a person to use it for any purpose for which he desires. Therefore, after the money is lent it is difficult to trace its end use. Even if the loan draw-down is made directly for the purpose for which it has been approved, monitoring end used is difficult and costly. A borrower with a hungry child or a sick parent / wife cannot be faulted for using the funds at his disposal for his immediate pressing requirement than the purpose for which the loan was approved.
e)   Building incentives for regular repayment in the loan contract itself. Say by giving a small loan with promise that in case it is repaid regularly the borrower would become eligible for a (slightly) larger loan.
f)    Realising that making available safe, secure, reliable, and easy means of small savings are often much more important than making loans for large parts of the population.

Over time, MFI have developed a host of such techniques which have proved their worth in enabling larger flow of resources to the small and micro end of the financial markets. Traditional banks by temperament and structure have been unable to address this critical requirement. Reasons are many and complex, and this short monograph will not even attempt to address it!

It is sad that the news article did not reveal if the National Summit on Microfinance even discussed these very important and relevant aspects of this industry.