Thoughts & Ideas

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.

Sunday, February 07, 2016

Whither or Wither Indian Banking?

The news article, Govt., regulators must take blame for NPAs: SBI chief, in The Hindu (issue dated 13th January 2016) reported that Mrs. Arundhati Bhattacharya, the Chairperson of SBI, in course of delivering the ASSOCHAM Foundation Day Lecture was of the opinion that the blame for banking industry’s high (and rising?) NPA levels should not be limited to them but all stakeholders should share the blame. This seems to echo the old saying that, “To err is human but to blame it on the other guy is politics”. Mrs. Bhattacharya tries to pin down the other principal stakeholders with specific examples for the increasing levels of NPAs in the banking sector. Specifically, according to her the rising level of NPAs were due to (a) promoters bidding aggressively on the back of good times and some of them were diverting funds, (b) the regulators were letting banks make loans with tenors of as much as 30 years, and (c) the Govt. was permitting policy uncertainty to continue. 

Such a view point either reflects poor knowledge of the role and function of banks and other financial intermediaries in society, or amounts to a clear repudiation of responsibilities by the banking profession in India. Coming from the Chairperson of SBI, the chances of the first possibility is low and that is the reason I find the views of Mrs. Bhattacharya disturbing. Unless, of course, she is preparing herself for a career in politics.

The incidence of NPAs in the banking system is akin to a manufacturing organisation making defective products. Manufacturing organisations set up quality control systems which encompasses 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. The quality is further tested as the product is used so that the quality can be further improved / costs brought down. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

One of the key functions of banks is to produce loans of consistently good quality and the production process in this context consists of having an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and good training, understanding how or why credit risks arise and having clear laid down credit 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 cannot be 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 made are repaid at the 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. Incidentally, RBI’s concerns on controlling NPAs seem also restricted on recovery rather than ensuring that probability of NPAs occurring is reduced. But this is another long story which I will save for another day. As such, one can safely conclude that the high and rising levels of NPAs in banks in India is a direct result of the failure of the banking industries quality control processes.

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 maneuver fall in operating margins, something rising NPAs result in. Third, by affecting ability of banks to provide liquidity services to the real economy (since the quantum of lending possible by banks is inversely proportional to rising NPA levels) the income and employment opportunities in the economy start getting drastically curtailed with rising NPAs in the banking industry. Finally, banks hold the institutional memory of credit history of all the actors in the real economy in their records. This institutional memory is hard and very expensive to recreate once lost. When NPAs become so high that a bank 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, and hits the real economy really hard by drastically reducing both income and employment opportunities in the economy. This is the primary reason that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones.  

Coming back to the specific issues mentioned by Mrs. Bhattacharya, it is the role of promoters and entrepreneurs to be optimistic about the future without which no society can operate, leave alone grow. And it is the role of banks to appraise loans so as to avoid adverse selection of potentially bad loans. Similarly, design of monitoring mechanisms in loan contracts should ensure that moral hazard problems arising from diversion of funds is avoided by raising early warning signals. I wish somebody had asked Mrs. Bhattacharya in that august gathering the reasons for banks not being in a position to fulfill these basic responsibilities. Isn’t appraising loans and monitoring them, including design and insistence of restrictive covenants, an essential part of credit risk management function of banks?

Mrs. Bhattacharya reportedly also mentioned that “Banks extended loans for long duration as much as 30 years while hoping funds would be recovered in 10 years”. I am not sure what she meant by saying this. A 30 year loan would have a 30 year repayment, it cannot be a 10 year loan nor a 40 year loan (unless restructured).  If it has a call option after 10 years, it becomes a 10 year loan if the call option is exercised but remains a 30 year loan if the option is not exercised.

This brings us to another key function of banks which is to address the maturity mismatch between deposits and loans, ie, its principal Liabilities and Assets. This function enables raising funds from, say, millions of small Saving Bank accounts for making large, longer term loans and investments with both the depositors and the borrowers being better-off, even after the bank as financial intermediary makes a decent profit in the process. This kind of maturity mismatch does create the problem of Asset-Liability management which can lead not just to Interest Rate risk (hits profitability of banks), but to severe liquidity problems (survival of the bank itself may be endangered). But it is part of the banking game which all bankers play all the time. Interest rate risk can be substantially covered by having floating rate interest rates on both deposits and loans. Since interest rates on deposits are sticker than that on loans, there always remains a certain quantum of residual interest rate risk on the bank’s books. However, if banks consider themselves as going concerns (and not gone concerns!), they can work out the risk of having a large Asset / Liability mismatch for a small portion of their total deposits without the overall risk being too large or unmanageable. This would enable financing long gestation projects while the bulk of the funding remains from short term sources. These are the basic skills of the banking profession and I hope Mrs. Bhattacharya does not mean that SBI lacks it!

Handling the credit risks arising from policy uncertainty by the Government is also a skill a banker brings, or is supposed to bring, to the table. This can be handled in various ways, say, by insisting on government guarantees (lazy banking), specifying low leverage levels, or innovative design of loan products (take out financing / refinancing / securitizing loans etc.), restricting the size of portfolio subject to such risks etc.

The disfunctionality of the Indian banking system is neither limited nor reflected solely in the high and rising level of NPAs, but is endemic in nearly every aspect of the industry. It is evidenced by large scale mushrooming of Ponzi schemes in which small depositors keep their hard earned savings with finance companies in the hope of getting a return which would not be negative in real terms because the banking system does not offer them a feasible alternative. Or, the difficulties faced by the smaller end of the market in getting loans which results in incidents like the call money racket recently in TS & Andhra, or the bad name brought on the micro-credit segment by a few unscrupulous operators. In practice it is a myth that private financiers are more expensive than our regular banking players if the transactions costs for delays, paper-work, bribery and worse are factored in. Even opening a simple deposit account at any bank requires tonnes of paper-work which can be quite intimidating (I had to fulfil KYC requirements to continue using by SB account which had been satisfactorily conducted for more than 30 years!).

Banks evolved by providing payment mechanisms to society. Even in this basic function the sheer inefficiency is sought to be remedied by having separate payment banks, inspite of the development negating the concept of economies of scope which is one of the key strengths of financial intermediaries like banks.

Ultimately, the problems being faced by the Indian banking industry can be traced to ineffective, backward looking top management. Unfortunately, the price is being paid by all Indians by way of difficulty in conducting their banking transactions, having few avenues of investment of their savings which give a decent positive real return at acceptable levels of transaction costs, or avoiding wading through a tsunami of paperwork in getting any kind of credit facility.