FSLRC on Financial Inclusion and Market Development

The FSLRC report identifies three problems that occur when regulators pursue the objectives of financial inclusion and market development like subsidizing credit for agriculture or increasing the flow of credit into certain states, for example:

1. When a bank is forced by regulation to provide more loans to open a branch in a non-profitable location, this imposes a hidden cost or tax on other branches, depositors and shareholders.
2. There could be dilution of accountability of the regulator due to conflicting objectives. For example, the number of households that participate in a certain financial product maybe increased quickly by reducing the burden of consumer protection. Similarly, the function of redistribution to exporters, by requiring banks to give loans to exporters, is in direct conflict with the function of protecting consumers who deposit money with banks.
3. The report takes the view that imposing costs on certain consumers for providing gains to others is a form of taxation. Such a selective taxation of certain consumers is inherently inefficient.

Due to the problems cited above, there is a need to clearly define the scope of objectives, powers and accountability of regulators. The report’s recommendations throw much clarity on three aspects-what the objectives of the regulators should be, how these objectives should be implemented and what the principles guiding policy-making should be. These are discussed below.

The FSLRC identifies three regulatory objectives of financial inclusion and market development:

1. Modernisation of market infrastructure or market process, especially those that relate to adoption of new technology.
2. Deepening consumer participation by undertaking measures that provide for the differentiation of financial products/services to specified categories of consumers, or that enlarge consumer participation in financial markets generally.
3. Aligning market infrastructure or market process with international best practices.

The report recommends the following institutional architecture for implementing the objectives identified above:

1. The Central Government should direct specific regulators on matters of financial inclusion. For example, regulators may be asked to ensure effective and affordable access to any specific financial service for a class of consumers. The Central Government is expected to reimburse the cost incurred by financial service providers in granting such in the form of cash or cash benefits and tax benefits.
2. Regulators should pursue a developmental strategy that seeks to achieve the objectives outlined. However, the goal of market development should be subordinate to the goals of consumer protection and micro-prudential regulation and should be pursued only when there is evidence of market failures that hinder it. The report recommends that the rule making process should involve features like cost-benefit analysis and notice-and-comment periods. There should also be ex-post evaluation of these initiatives, assessing their costs and benefits.
3. In initiatives that involve multiple regulators, the FSDC (Financial Stability and Development Council) will play the dual role of a think-tank (measuring the progress of initiatives, analysing past initiatives, recommending new ideas etc.) and be the agency that coordinates between regulators.

The report recommends that the regulators and the central government keep the following balancing principles in mind while formulating policies:

1. Minimize any potential adverse impact on the ability of the financial system to achieve an efficient allocation of resources.
2. Minimize any potential adverse impact on the ability of a consumer to take responsibility for transactional decisions.
3. Minimize detriment to objectives of consumer protection, micro prudential regulation, and systemic risk regulation.
4. Ensure that any obligation imposed on a financial service provider is commensurate and consistent with the benefits expected to result from the imposition of obligations under such measures.

Overall, the framework proposed by FSLRC focuses on regulatory functions that address market failures obstructing the efficient functioning of the financial system. The Commission is of the view that financial inclusion and market development are functions that aren’t strictly regulatory in nature. Financial regulators performing these functions could lead to distortions in the market (hidden costs, inefficient taxation and dilution of accountability). Such functions should therefore be pursued in case of market failures that hamper equitable distribution of financial services and market development.