A woman receives a micro-loan during a meeting organized by SKS Microfinance Ltd. in Sadasivpet, India. (Photographer: Adeel Halim/Bloomberg)

Financial Inclusion: Have We Been Approaching The Problem All Wrong?

Any conversation around financial inclusion inevitably turns into one around banks and access to banking. Do we have enough banks? Do we have enough kinds of banks? Do these banks have enough branches and business correspondents? And do all Indians have bank accounts?

That’s the thought process that drove the Jan Dhan Yojana, which intended to ensure bank accounts for all Indians. It’s the same thinking that pushed the Reserve Bank of India (RBI) to create a new category of lenders called Small Finance Banks. A similar consideration forms the backbone of the new branch banking guidelines, which aim to spread the network without the cost associated with traditional brick and mortar branches.

But what if access was not the problem in pushing more savings towards financial assets? And, on the liability side, what if the stronghold that money lenders have over Indian finance was more about insurance rather than banking?

Those are some of the issues put up for debate by the RBI-appointed Committee On Household Finance, headed by Tarun Ramadorai, Professor of Financial Economics at the Imperial College. According to the report, the average Indian household holds 95 percent of its assets in physical assets. Real estate, gold being prime among them. Only 5 percent is held in the form of financial products. The phenomenon has been well-documented but remains ‘stubbornly persistent’, said the report.

“The lack of trust in financial institutions partly explains the tendency of households to avoid financial products and invest in physical assets such as gold instead,” the report added.

While it is tough to measure an intangible like trust, the report notes that households often have a negative perception of formal financial service providers, exacerbated by the occasional poor experience. This perception appears to be more prevalent in lower income households, where it is felt that the formal financial services are the prerogative of the elite.

“High transactions costs and bureaucratic impediments to efficient participation create a high “nuisance factor” for households hoping to engage in formal financial markets,” the report notes.

It would be unfair to suggest that Indian regulators have ignored such intangibles in their quest to achieve greater financial inclusion. The RBI, for years, has stressed the need for financial literacy. It has tried to make the banking market more competitive in the hope that with increased competition will come better and differentiated services. The Banking Ombudsman Scheme has been in place for years and a Financial Redressal Agency has been suggested by the Financial Sector Legislative Reforms Commission.

If neither of these have worked, perhaps it is time to think differently, suggests the report.

“...Demand-side considerations cannot be solved through regulation and can only be addressed by a supply-side environment that dynamically innovates to address demand characteristics observed amongst Indian households,” write the authors of the report.

One part of this is to create products that are simple, intuitive and tailored to meet the needs of the end consumer. Another, suggests Ramadorai, is to use technology to overcome the reluctance that low income earners may have in interacting with the formal financial system.

One of the things we propose is that we should de-personalise some of these interactions by using technology. You might say that poor households don’t have access to technology but I don’t think that’s quite right since cellphone penetration in the country is quite high. So the question is how can we do things at a price point that is quite low, in a seamless fashion and de-personalise the transaction for people.
Tarun Ramadorai, Chairman, Committee On Household Finance

The Link Between Insurance And Informal Finance

The committee also tries to switch the approach taken towards financial inclusion from a liabilities perspective.

According to the report, unsecured debt accounts for close to two-thirds of total liabilities for the very poor and one-third for the rich. “The picture that emerges is one in which Indian households are relatively less indebted than their foreign counterparts, but those that take on debt are more likely to have no collateral to secure it, which leaves them exposed to repayment risk even in old age,” the report notes.

The problem, according to the committee, may lie more with the lack of penetration of insurance products than the inability of low income households to access formal banking products.

Research done by the committee suggests that events such as loss of crop, medical emergencies, damage to property etc account for major financial losses in more than 60 percent of the cases. Job losses, an increase in costs of agricultural inputs and a deterioration in overall market conditions are other factors that create financial stress.

In order to cope with such risks, most households end up approaching the informal financial system since penetration of insurance products is low. This, in turn, exposes households to the prohibitively high cost of informal finance and often leads to a debt spiral.

“Formal bank loans are almost irrelevant as a means to cope with unexpected emergencies. Instead, we document a trade-off between the take-up of insurance products and the reliance on non-institutional sources of unsecured credit,” the report notes.

In order to tackle some of these cross-sectoral issues, Ramadorai is pushing for greater regulatory coordination and pitching for a ‘regulatory sandbox’.

We have this tendency to regulate from a product perspective in silos...But the point is that from the household’s perspective, it doesn’t think of optimizing product by product. So we need a regulatory system which operates in the same way (as households).... Also, we have suggested a regulatory sandbox. Within that, we think there is potential for a inter-regulatory framework to be set up which allows financial technology firms to get an integrate perspective of the regulations and then look for solutions to some of these issues.
Tarun Ramadorai, Chairman, Committee On Household Finance