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