Two reports, one exclusively on financial inclusion, under the chairmanship of C Rangarajan and another under the chairmanship of Raghuram G Rajan, were submitted to the government in 2008. Whereas both the reports agree on the diagnosis of exclusion, they differ on the prescription for inclusion. A discussion of the differences, similarities and additional prescriptions.

Rajaram Dasgupta (dasgupta@nibmindia.org) is with the National Institute of Bank Management, Pune.

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Whereas the Committee on Financial Inclusion under the chairmanship of C Rangarajan (henceforth CRC) devoted solely to financial inclusion, A Hundred Small Steps (Planning Commission 2009) under the chairmanship of Raghuram G Rajan (henceforth RRC) devoted a c hapter to “Broadening Access to Finance”, implying financial inclusion.

A restrictive definition of financial exclusion puts the emphasis on specific services and their absence, which are sometimes described as essential: “services that do not have an impact on the household’s budget, but (they) represent at the same time essential elements for the individual’s life: subsistence, security and participation to the economic and social life” (Anderloni and Carluccio 2007).

An additional dimension to financial exclusion includes under-banked individuals, who while not un-banked use their account very little (ibid). A wider definition of financial exclusion thus is “the inability to access necessary financial services in an appropriate form” (Sinclair 2001). Whereas the former is a necessary condition, the latter is a sufficient condition for financial exclusion.

Although financial exclusion is the “inability of some societal groups to access the formal financial system”, this is invariably experienced by poorer members of society more (Molyneux 2007). These people are frequently unable to obtain other social provisions; financial exclusion often exacerbates other kinds of exclusions.

The many causes for financial exclusion are: (i) geographical, i e, non-existence of branches in an area, (ii) access exclusion, i e, restricted access because of bank’s risk

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tions of the population refuse to approach banks, believing that any request would be turned down (Anderloni et al, op cit).

Extent of Financial Exclusion

Whatever be the determinant, a good proportion of the population does not have access to formal financial services. Twentytwo, 14, 11 and 9% in Italy, Australia, UK and European Union, respectively do not have a deposit account (Molyneux 2007). According to CRC, 73% of Indian households are not indebted to formal fi nancial institutions. In this case the worst victims are marginal farmers, agricultural labourers, artisans and members of the scheduled tribes. The Reserve Bank of India (RBI) has identified 256 districts, where the credit gap is more than 95%.

According to the Invest India Market Solution Survey, 2007 (IIMS) data, used by RRC, only 14% of agricultural wage labourers have a bank account, vis-à-vis 95% of businessmen; only 34% of the lowest quartile of the population has cash savings vis-à-vis 92% in the highest quartile. Among the “cash s avers”, 86% in the highest quartile, vis-à-vis only 50% in the lowest quartile have access to banks. This is financial exclusion as per the “necessary” condition. With regard to credit, 30% in the lowest quartile take a loan vis-àvis 16% in the highest quartile. But whereas in the lowest quartile only one-tenth is bank loans, in the highest quartile it is 50%.

Similarly, 14% of the lowest quartile against 69% of the higher quartiles have life insurance cover. Thus, RRCin comparison to the CRC has more of a concern for d eposit and insurance services. Both, however, look only at the necessary condition, not at the sufficient condition. N either analyses the six causes of financial exclusion.

CRC Observations

CRC defines financial inclusion as “the process of access to financial services and timely and adequate credit needed by vulnerable groups such as weaker sections and low income groups at an affordable

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cost”. It identifies the existing systems like the District Level Consultative Committee (DLCC) and the State Level Banker’s Committee (SLBC) for implementation of the State Rural Financial Inclusion Plan ( SLRFIP) and the National Rural Financial Inclusion Plan (NRFIP). It suggests constitution of a National Mission on Financial Inclusion (NMFI). The DLCC is to draw up village-wise household maps not having access to formal credit sources. This entire structure resembles the Service Area Plan (SAP), which did not succeed in the past. The CRC not only retains the old structure, it retains the old target regime also. The CRC, however, does not throw any light on why the weaker section credit target of 10% has not been achieved by most of the banks. Neither did it analyse the sad p erformance of the SAP.

It is not that the “target” system does not work. A target for extracting performance is essential in any commercial organisation, where there is a (i) distinct chain of control, (ii) well-defined corporate objective,

(iii) clear relationship between the implication of the target and the corporate objective, and (iv) in most of the cases linkage between target achievement and incentive. The CRC does not discuss any incentive for the financial institution per se. It has also not talked about any punishment meted out by the government. It has mentioned tax incentives for Regional Rural Banks for their financial health, which has little to do with financial inclusion. In the absence of such a reward and punishment framework, it is difficult to appreciate why a corporate will sweat it out to achieve the target set by SLRFIP, unless the short-run business with these excluded entities is highly profitable, or the bankers visualise the long-term commercial gain. Neither seems to be true.

The CRC in its supply mechanism has emphasised some of the old wisdoms like:

(i) advisory services to the poor, (ii) training the borrowers, (iii) bringing attitudinal change in the branch staff, etc. It does not discuss “selling of the product”. Provision of infrastructure and capacity building support is an important necessary and enabling condition, not the sufficient condition for generating income, creating surplus, repaying the bank loan and finally instilling faith in the banker to do business with them. “Wage for livelihood” rather than “credit for self-employment” may be more popular among poor. It is difficult, no doubt. It is however, mandatory to ensure that credit earns income.

The CRC has nevertheless suggested a few technical improvements in (i) mortgage requirements, (ii) documentation,

(iii) duties, (iv) business facilitator norms,

(v) incentive mechanism for the business correspondents, and (vi) credit to oral l essees and tenant cultivators.

The CRC has rightly made a recommendation to RBI to allow more Local Area Banks (LABs). This, however, failed to v isualise the place of the LAB in the larger financial system. With respect to the microfinance bill, it just recommends the inclusion of Section 25 Companies in the list; it does not advocate an exclusive legislation by which all microfinance institutions operating in the country comes under a single regulatory framework. It does not highlight the inadequacy of deposit insurance in the bill (Dasgupta 2008). It has, however, recognised the need of separate category of Microfinance – Non-Banking Finance Companies (MF-NBFC) providing all services to the poor, without any relaxation on start-up capital and subject to the regulatory prescriptions applicable for NBFCs . It suggests different regulatory aspects of microfinance under single mechanism within RBI.

CRC has taken a bold step in bringing out the demand-side elements of financial inclusion like: (i) low productivity, (ii) no local value addition, (iii) poor market linkages, (iv) risk in agricultural activity,

RRC Observations

Unlike the CRC, the RRC looks at financial inclusion more from the savings angle by stating, “the most important financial services for the poor are vulnerability reducing instruments. These include savings, remittances, insurances and pension needs”. Households need access to financial services for contingency planning and risk mitigation, building buffer savings, allocate savings for retirement and purchasing i nsurance products for insurable contingencies.

Once these needs are met, households typically need access to credit for livelihood creation as well as consumption and emergencies. It finally reinforces its stand by stating “an exclusive focus on credit can lead to undesirable consequences such as over-indebtedness and inefficient allocation of scarce resources”. Second, the RRC likes to move away from the target and government intervention to market forces.

The RRC has correctly observed that a lthough mandated branching in rural areas has made it easier for banks to reach a significant proportion of people, branches have not gone out of their way to attract the poor, and the rural branches are seen as a burden rather than offering opportunities. The RRC has again rightly observed that priority sector coverage is so broad that banks migrate towards the bankable within the priority sector rather than the excluded indicating the inappropriateness of the target approach. The RRC observes that the financial sector does not ignore the poor because of biases but because of a high transaction cost. This may not be completely true; there are indeed attitudinal biases too (Dasgupta 2006).

The RRC, however, is correct to comment that the interest rate ceiling reduces banker’s desire to service the truly excluded; higher fixed cost and higher perceived credit risk imply a higher not lower interest rate. According to the RRC report,

(iii) A plethora of bureaucratic norms and paper work is imposed to check corruption, which reduces the flexibility and a ttractiveness of credit.

The World Bank-NCAR Survey reveals positive correlation between bribe amount and speed of loan approval.

The RRC describes the financial canvas as: (i) commercial banks with highly paid urban recruited staff lacking local knowledge; (ii) a cooperative structure, driven by borrowers at all levels with each layer adding cost, lacking right governance and right incentive structure, with top-down financing pattern vis-à-vis the inter national system with bottom-up approach and members’ savings channelled through

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careful member control into local loans ensuring high repayment; and (iii) microfinance institutions with an unclear regulatory environment, unable to raise fi nance, lacking a well-developed management information system and inaccessible to affordable human resource capacity.

The RRC therefore envisions a new structure for financial inclusion which is efficient, innovative and cost-effective; and considers financial services to the poor as a business opportunity rather than charity.

Integrated Structure

It proposes an integrated organisational structure: (i) creation and promotion of Small Finance Banks (SFBs), and (ii) strong linkage between large mainstream banks and SFBs.

The SFB should be local, because it will then have better information about creditworthiness of the intending borrowers and will be in a better position to understand their business needs. The SFB needs to be small because the centre of decisionmaking process will be close to the loan officer facilitating direct approval without much documentation, delay and loss of i nformation. Finally, the SFB should be private, as the manager may then have the right incentives in handling flexible and low documentation loans if he has a significant stake in the enterprise and its future. These local, small and private SFBs having a low cost structure and the right incentives will allow the loans to be p rofitable.

According to the RRC a strong negative correlation has been found between the size of the bank and the ability to lend to small entities in the United States (Berger et al 2005). US data shows that small businesses with local banking relationships visà-vis other small businesses, received loans at lower rates and lower collateral, enjoyed greater credit availability, and had better protection against the interest rate cycles (Petersen and Rajan 1994). In the UK, new innovations in financial inclusion strategies have often come from credit unions, community banks and non-profit banking institutions (Planning Commission 2009: p 60).

The unviability of small banks in India according to the RRC is because of high fixed costs, a poor governance structure, excessive government and political interference and on top of everything else, an unwillingness and inability of the regulator to undertake prompt and corrective action. The SFBs, therefore, need to be given substantial care by the regulator in applying “fit and proper” criteria while licensing and ensuring greater regulatory oversight later.

The RRC highlights that in the post-east Asian crisis a sample of 77 largely private small banks in Indonesia was profitable and had a higher return on assets in comparison to the entire banking system. The RRC finds a large number of dynamic local microfinance institutions with a good track record of reaching the poor. It visualises enough scope for capital infusion, provided promoters dilute their stake.

Guidelines for SFBs are both liberal and stringent. SFBs should be free to choose their location and business model unlike LABs in contiguous districts, allowed to provide a comprehensive suite of financial products, expected to provide mainstream products, required to have lower amount of regulatory capital consistent with the initial intent and not subject to interest rate regulation. On the other hand, they are expected to be under rigorous surveillance right from the beginning, focus on performance indicators like capital adequacy, focus on governance including strict prohibitions on self-lending, and provide greater monitoring and more frequent onsite inspections especially in the beginning.

The RRC rightly advocates formation and nurturing of SFBs or LABs, which may one day graduate to become a mainstream bank (Dasgupta 2006), to work with the bottom of the pyramid in a more meaningful way. Without reflecting on the microfinance bill, it visualises two alternatives for the existing microfinance institutions (MFIs): (i) remaining a credit institution as a non-banking finance company (NBFC) or a Section 25 company or (ii) a business correspondent (BC) of large banks for providing savings facilities. Others having a good track record and strong willingness may like to become an SFB. The BCs need to be given a good amount of market freedom. What is required is an enabling environment rather than policing control.

The RRC has strongly recommended r evisiting the priority sector credit norms. It suggests only (i) direct agriculture and

(ii) weaker sections to be under this category. A framework for priority sector norms based on (i) importance of the s ector/ segment in the economy, (ii) transaction cost, (iii) risk perception of the bank, and

It then comes out with a market-based incentive approach of trading “Priority Sector Lending Certificate (PSLC)” in an appropriate market for ensuring the achievement of target. A nodal agency will issue a PSLC to any eligible loan, which may be traded under appropriate terms and conditions for meeting this shortfall. Price, determined in the market will signal for whom this business is unprofitable, and who should actually do the business. What is needed is effective management of the subsidy for achieving the desired goal.

One of the suggestions for subsidising financial entities is auctioning of services with negative bids. For enabling the poor to use the benefits of the financial markets, it recommends (i) a good amount of penetration of technology and (ii) subsidising the provision of PAN numbers of poor clients who wish to participate in this market. The RRC wishes the government to follow the Mexico model of providing centralised back office services to enable financial institutions to scale up financial services to poor.

The RRC shows from an empirical study, that total cost of small loan is 25 to 30% (Sinha and Subramanium 2007). It cites a nother study to note that the p enetration rate of microfinance is much more in the countries without any ceiling on interest rate.

The RRC, therefore, rightly advocates a “liberalised” but not “deregulated” interest rate regime, which constitutes: (i) a transparent way of communicating to b orrowers upfront about all input costs and public disclosure of margins on loans, (ii) an effective system for tackling g rievances, and

(iii) a system of providing PSLC to those loans only in which the interest rate fulfils the test of “reasonable margins”.

Common Ground

Both the CRC and RRC emphasise risk mitigation preceding micro insurance. These

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include soil and water conservation, herd vaccination, preventive healthcare, safe drinking water, sanitation, etc. The CRC recommends substantial investments in human development, electricity, road, irrigation, post-harvesting facilities, etc, in financially excluded and rural areas; and the creation of a calamity relief fund. The RRC puts emphasis on health insurance, especially for poor women, and recommends creation of a health mutual and provision of reinsurance.

Both prioritise insurance of agricultural production, and recommend a shift from crop to weather insurance and ensuring timely settlement; quick legislation of the Warehousing Bill and its implementation for combating price risk; and an initiative towards improving the transactional efficiency of the spot market. Whereas the CRC recommends organising the unorganised to achieve economies of scale, the RRC s uggests expansion of initiatives like e-choupals so that products can be sold at the village itself at attractive price bypassing the ahratiyas who often collude to make lower payments to small farmers. It also recommends allowing farmers to sell the produce at any mandi that offers an a ttractive price. It requires a network of a reliable warehousing and assayers for expanding the outreach of a new generation of “spot” exchanges.

Conclusions

Both the reports largely converge in their diagnosis of financial inclusion. However, whereas the CRC drags the government into micro-management, the RRC confines it to the policy level and macro market only. But both highlight the government’s role in infrastructure development, human capital formation and legislation process.

The following steps may expedite financial inclusion, a forerunner of economic and social inclusion, leading to sustainable inclusive economic growth and development:

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References

Anderloni, Luisa and E M Carluccio (2007): “Access to Bank Accounts and Payment Services” in Luisa Anderloni, Maria Debora Braga and Emanuele Maria Carluccio (ed.), New Frontiers in Banking Services (Heidelberg: Springer).

Berger, Allen N and Nathan H Miller (2005): “Does Function Follow Organisational Form? Evidence from the Lending Practices of Large and Small Banks”, Journal of Financial Economics, Vol 76, May.

Dasgupta, Rajaram (2002): “Priority Sector Lending: Yesterday, Today and Tomorrow”, Economic & P olitical Weekly, Vol 37, No 41.

Molyneux, Philip (2007): “Specific Economic Gains” in Luisa Anderloni, Maria Debora Braga and Emanuele Maria Carluccio (ed.), New Frontiers in Banking Services (Heidelberg: Springer).

Petersen, M A and R G Rajan (1994): “The Benefits of Firm-Creditor Relationships: Evidence from Small Business Data”, Journal of Finance, Vol 49.

Planning Commission (2009) “Broadening Access to Finance” (Chapter 3) in A Hundred Small Steps: Report of the Committee on Financial Sector Reforms (New Delhi: Sage).

Rangarajan, C (2008): Report of the Committee on F inancial Inclusion, Ministry of Finance, Government of India, (http://www.nabard.org/report_ com financial.asp).

Sinclair, S P (2001): Financial Exclusion: An Introductory Survey, Centre for Research into Socially I nclusive Services (Scotland: Herioc Watt U niversity).

Sinha, J and A Subramanium (2007): The Next Billion Consumers: A Road Map for Expanding Financial Inclusion in India (Boston Consulting Group).

World Bank-NCAER (2007): Rural Financial Access S urvey (Washington DC: World Bank).

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