Government Policies and Financial Inclusion

Markets typically exist within the boundaries set by the state. The financial markets are no exception to this. Mobilisation and allocation of capital – the key roles of the financial system – are done within the framework defined by the government. From nationalisation of banks and significant economic ownership, to guiding the allocation of capital to priority sectors and regulating various aspects of the financial sector, the Indian government has played just about every conceivable role in the nature of financial intermediation.

Programmes and policies

The government has also tried to increase financial access primarily through the Reserve Bank of India and other regulators. The most prominent strategy it has followed is the priority sector lending by banks, which requires banks to extend 40% of their lending to sectors defined as preferred (such as agriculture) by the government. Banks and insurance companies have been given targets to open savings bank accounts and provide micro insurance policies respectively. The government has also used direct influence over public sector institutions to ensure extension of services at its discretion.

The Self Help Group-Bank linkage programme (SBLP); Kisan Credit Card (KCC) scheme for farmers; Rashtriya Swashtya Bima Yojana (RSBY); financing and refinancing of various cooperative banks, regional rural banks and public sector commercial banks that extend credit to rural clients, especially farmers; and various state level programmes for extending credit to rural areas are examples of more direct efforts. Many of these steps have had significant positive impact on financial access. For example, by March 2009, there were over 61 lakh savings-linked SHGs and over 42 lakh credit-linked SHGs across the country with cumulative credit of over Rs. 50,000 crore accessed since 1992. KCC has become the main source of short-term credit for farmers. As on March 2010, over 5 crore ‘no frills accounts’ had been opened. Cooperative banks and regional rural banks have the highest outreach with respect to branch penetration in rural areas.

Intensions and consequences

However, these efforts are driven not just by an intention to enhance welfare, but also by electoral considerations, because financial services, particularly credit, are perceived to be effective tools for reaching the electorate quickly. Given the institutional infrastructure of India, credit can be quickly extended through the thousands of service points. Research by Professor Shawn Cole (Harvard University) shows that Indian public sector banks’ agricultural credit increases by 5-10 percentage points in an election year, with large increases in districts in which the election is particularly close. Clearly, the separation of political considerations and business objectives is hard to achieve, but this may have unintended consequences.

First, political exigency may not be compatible with innovation because the imagination and experimentation that goes into the development of real solutions cannot be dictated. So, for example, though it is good to have Rs. 47,000 crore disbursed to farmers through KCCs, a closer look at the scheme’s lending mechanism reveals significant weaknesses. It allows considerable repayment flexibility with negligible monitoring and relies on land as collateral, which is very challenging to enforce for a lender. Similarly, less than 11% of ‘no frills accounts’ opened at RBI’s behest are actually used. This is because though the banks fulfilled the “targets”, not enough was done to ensure that clients access these accounts conveniently.

Second, government’s continuous and relatively unconditional support for certain institutions has distorted their incentives. For example, though many cooperative banks have performed very poorly (according to the Task Force on Revival of Cooperative Credit Institutions (2004), a quarter of them had eroded their net worth), the government has continued to refinance and re-capitalise them. Recent revitalisation efforts have tried to improve capacities of these institutions, but there is still little emphasis on addressing the basic issues of incentive alignment and financial design (product mechanism and pricing). This has created a “too political to fail” implicit guarantee system, not unlike the “too big to fail” implicit guarantee. This leads to a differential playing field between institutions backed by the government and private efforts, rendering the latter at a disadvantage.

Third, some government interventions, though looking beneficial in the stage one analysis, may have negative effects on the financial system in the long run. For example, the loan waiver schemes may help some people in the short run, albeit not the poorest, but they do so at the cost of changing the incentives facing the rural borrowers, giving a strong reason to delay repayments till the next loan waiver. A more complex example is of the interest rate cap on savings bank account. This cap, which probably comes with the implicit understanding that banks will use these low cost funds to lend to priority sectors, becomes regressive especially in rural areas, where, given the high transaction costs for using bank accounts, this low return on savings might act as an incentive to hold cash. This goes contrary to financial inclusion efforts.

Fourth, when governments venture into direct financial services provision, it creates competition between the government and the market. Since the government has discretionary powers, it can legislate or regulate its way out of any competitive situation. The recent micro finance Ordinance issued by the Andhra Pradesh government is an example of this. In AP, the commercial microfinance sector seemed to be posing a direct challenge to the government-run programme, which was reportedly leading to attrition in the latter. This then leads to the question: Can a market participant regulate objectively?

Creating distortions in the long-run

All these indicate that many of the government’s efforts, though often well-intentioned and having positive outcomes in the short-run, create distortions that may lead to inferior outcomes in the long-run. The exigencies of the political process have three underlying features: a) they restrict thinking only about immediate outcomes; b) their timelines are dictated by electoral cycles; and c) their focus is on easily visible outcomes. Perhaps that is why there is so much focus on disbursing credit and opening bank accounts, with little importance to sustainability and effectiveness of services.

The governments could improve the design of their programmes and interventions, but the structural differences in workings of a political process and market institutions will remain. Should the government step back and just focus on regulating the system? There is no simple answer to this question. One way to approach this question is to ask: if the governments don’t intervene, would the markets anyway enter and contribute to financial inclusion? It is difficult to say for sure, because this requires predicting behaviour of markets under completely different situations. But what one can say is that markets more or less respond to incentives and are likely to pursue profitable strategies under conducive environments with low reputation and political risk.

Creating a conducive environment

So, the Government should focus on creating an environment where financial institutions and markets can expand in an orderly manner, minimising the need for direct government intervention. This can be done in many ways, especially by: a) providing public infrastructure (like connectivity; UID (one of the biggest contributions by the government to financial inclusion probably is the creation of the UID infrastructure compared to many direct interventions over the years); law and order; and currency chests to enable cash movements) that helps reduce transaction costs for serving remote areas; b) encouraging competition among financial providers (giving more bank licenses, creating level playing field); c) focusing on rules-based regulation to minimise political risk that springs from discretionary regulation by governments/regulators; and d) using quality research to assess the long-term implications of big policy decisions like loan waiver. These steps should help gradually improve the sustainability and quality of financial inclusion. Otherwise, we will continue with this sub-optimal equilibrium of short-term financial inclusion numbers at the cost of long-term sustainability and high quality service.

Abridged version of this article first appeared in The Hindu Business Line.