Financial inclusion is not a new goal for India and it has always been the stated aim of financial sector policy to seek to include four critical segments: project finance, small and medium enterprises, low-income households and farmers. More recently, infrastructure and municipal finance have been added to the list. I can think of three distinct phases in the Indian journey towards this goal.
The first phase was pre‐1994, before the arrival of the new-generation private sector Deposit taking Institutions (DIs). During this phase, post the nationalisation of DIs almost two decades earlier, the system was dominated by the government owned DIs that sought to achieve financial inclusion largely through branch‐based efforts, for small businesses, low-income households and farmers and through specialised Development Finance Institutions (DFIs), for project finance. While researchers (Pande and Burgess, 2005) found clear impact on poverty wherever branches were opened by these DIs, the impact on the overall challenge of financial inclusion was very limited. In addition, asset quality/solvency and cost‐to‐serve were the serious challenges associated with the model and even led to a few DIs ending up with a negative Net Worth. These solvency problems were however, not visible to their depositors since the DIs were largely government owned and were, almost automatically, recapitalised. Liquidity was also not much of a challenge during this period due to the limited nature of inter‐DI trading and liquidity transfers therefore largely taking place between various internal divisions of the DIs.
For a variety of reasons, the efforts on DFI led project finance also did not make the desired level of progress. Post the 1991 liberalisation of the Indian economy, most of the DFIs eventually became insolvent and transformed themselves into full service DIs by raising capital through either commercial sources or recapitalisation by the government and for a period of time almost entirely ceased project finance activities.
In the second phase post‐1994, several new-generation private sector DIs were licensed and parallely there was the emergence of high-quality institutional equity market infrastructure (SEBI, NSE, NSDL) coupled with the entry of Foreign Institutional Investors (FIIs). As a direct consequence of these developments, there were some improvements on the inclusion front, particularly for middle-income households for products such as home and two-wheeler loans offered to them through a combination of branch‐based efforts and a few specialised intermediaries, as well as for larger companies seeking equity finance directly through capital markets. There was however, very limited progress on the inclusion of low‐income households, small and medium enterprises and farmers. During this phase there were distinct improvements in asset quality and solvency of DIs on account of the fact that there were more DIs that were closer to the customer and some degree of inter‐DI transfer of assets created visibility on asset quality. However, for this very reason and because of the fact that the government was no longer the sole owner of all the large DIs, there was a definite increase in the risk of liquidity and solvency shocks.
The third phase started in the late nineties and has seen the emergence of specialised Non-Deposit Taking Institutions (NDIs) focussing on financial inclusion. They have started to make contributions to inclusion for various segments including short-term liquidity needs of low-income households through jewel loans and microfinance; second-hand vehicle finance and other kinds of equipment and commercial vehicle finance at the retail end of the spectrum; and debt finance for infrastructure and distressed assets at the wholesale end. These NDIs have largely accessed liquidity via the DIs with some access to debt-capital markets and have brought to bear additional equity capital of their own to cushion the DIs against possible credit risks arising from these less familiar businesses. With the exception of asset problems arising out of the challenge posed by the Andhra Pradesh government to the RBI on the regulation of financial institutions (both DIs and NDIs), the quality of assets originated by these specialised NDIs has been consistently strong. This approach, even though narrowly product-focussed, seems promising and was also underscored by RBI’s Narasimhan Committee in 1998.
However, during this period for some reason, official policy seems to have become considerably more hawkish towards these specialised NDIs viewing them as competitors of DIs instead of, as had been originally envisioned by the Narasimhan Committee, as extenders of the outreach that DIs could provide on their own and as innovators and risk takers that would cushion the DIs from credit losses and costs arising from these newer businesses, through their additional capital and their much lower-cost delivery structure.
Rather than encourage the deployment of additional capital by these NDIs and the naturally emerging specialisation in roles between DIs and NDIs, policy seems much more supportive of direct efforts by DIs (through owned branch networks or agents who don’t have capital at risk) almost to the point of compelling them to do this, even though the rising tide of non-performing assets amongst the DIs, particularly in the “priority” sectors and the failure of the no-frills savings accounts to take off, seems to challenge the wisdom of such an approach and harks back to the first, pre-1994, phase of this journey. In my view, this approach is not only not serving the interests of high-quality financial inclusion but is also potentially building-up a non-performing asset bubble even in systemically important DIs that may become too large for fresh rounds of recapitalisations and farm-loan waivers by the central government to be feasible. This could therefore start to weaken systemic stability because the institutions at risk will no longer be small Regional Rural Banks and Cooperative Banks, as in the past, but large systemically important DIs.
The third phase has also seen the emergence of another set of very important phenomena – the increase in the use of non-branch channels such as ATMs for cash and non-cash channels for payments (credit cards and electronic transfers) and integrated customer level sales channels for multiple financial products (bancassurance, Business Correspondents). These trends, which are currently in their early stages, coupled with efforts such as the Universal Identity (Aadhaar), have the potential, over time, to bring about some fundamental change in the very architecture of financial services and their regulation.
In my view, all of these experiences and concerns need to be borne in mind as we think ahead on the directions we should pursue if we want to significantly impact inclusion while ensuring that depositor protection, systemic stability and national growth objectives are not compromised. We must not repeat phase one mistakes or fail to capitalise on the momentum of phase three. It seems clear to me that issues such as customer protection are going to become more and more important even while we are pursuing financial inclusion goals. And, while the country definitely needs to improve outreach in a manner that achieves these objectives, it also needs to ensure that there is the rise of very large financial institutions that are equal to the task of meeting the project, infrastructure and municipal finance needs of one of the fastest growing economies in the world while simultaneously ensuring systemic stability.
IFMR Trust’s (the “Trust”) goal has been to identify and make progress on directions that make access to financial services universal but do not compromise systemic stability. The Trust has taken the carefully considered view that the only way to do this is to build on the separate natural strengths of DIs and specialised NDIs. In the Trust’s view the DIs need to grow into directly regulated, very transparent, very large institutions while the NDIs need to proliferate with regulatory oversight coming not from the regulator directly, but indirectly from the DIs and the capital markets.
One of the goals that the Trust has set for itself has been to demonstrate that NDIs that simultaneously meet the goals of extremely low-cost financial inclusion and very high-quality of customer protection are not merely a utopian ideal but are indeed feasible to build and operate. Since 2008, the Trust team has made excellent progress on this goal. Through IFMR Rural Finance and its Kshetriya Gramin Financial Services (KGFS) companies, they have delivered on a new approach to origination that takes a Wealth Management approach (rather than a product-selling approach) and yet keeps costs low by bringing to bear cutting-edge technologies and superior training of locally hired staff. This approach tightly customises a portfolio of financial products for a household depending on its unique needs and in the process, transfers complexity from the household to the provider while holding the provider responsible for the quality of guidance and the appropriateness of the products offered to the household on a longer term basis.
On the issue of provision of liquidity from the DIs to the NDIs, while maintaining enhanced oversight of the NDIs, the view that the Trust has taken is that there is a need for large national level bridge institutions that focus entirely on linking the myriad NDIs that are necessary for financial inclusion with the large DIs and capital markets and effectively “transmit” systematic risk and liquidity, while retaining idiosyncratic risk with the original NDIs. Towards this goal, through IFMR Capital, they have made important contributions towards demonstrating the manner in which large volumes of liquidity can be provided from DIs and capital markets to NDIs and have innovated several products that enable this liquidity transfer to happen smoothly and without moral hazard.
The Trust has also contributed strongly to the emerging dialogue on national regulatory systems with regard to customer protection and to the direction in which the regulation of DIs and NDIs must proceed.
Dr. Nachiket Mor, Chairman, IFMR Trust
