Sunday, 24 March 2013

Financial Inclusion- Creating wealth at the bottom of the pyramid

“The importance of finance to economic growth has also frequently been ignored by economists.”

Fed Governor, Frederick Mishkin in 2005


We had two committees in past which give definitions of financial inclusion: Rangarajan Committee on Financial Inclusion which defines it as “the process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost.”

Raghuram Rajan Committee on Financial sector Reform which described it as “Financial inclusion, broadly defined, refers to universal access to a wide range of financial services at a reasonable cost. These include not only banking products but also other financial services such as insurance and equity products.”
Source: Adapted from the Rangarajan Committee Report

Source: IISS, 2007

The two definitions basically, defines the Financial Inclusion as availability of diversified range of financial products to all the people residing in the country, which was earlier accessible exclusively to urban section of society. Here it is important to note that financial inclusion is not only about credit, rather it talks about all three levels of access: Contingency Planning, Credit and Wealth Creation. It empowers, especially, the poor to take control of the lives and get connected to main stream of country’s economic development.

India lives in its villages. The Rural population (% of total population) in India was last reported at 69.90% in 2010, according to a World Bank report published in 2012. Of late the rural economy of India is transitioning from a mere agrarian society to encompassing other areas of professions like manufacturing, service industry etc.  From 1999 to 2009, 75% of all new factories came up in rural India, and 70% of all manufacturing jobs were created there. Therefore, in order to streamline the revenue that is being generated from this sector, it is very important to provide efficient banking solutions to the bottom of the pyramid population. This brings into light the importance of financial inclusion.
The rural population in India mostly belongs to the low income, illiterate group. They rely on local money lenders for any financial solution that they seek. The local money lenders usually take advantage of the illiteracy aspect of the rural low income Indian and offer him the financial solution that he is seeking for at a very high interest rate. This is leading to increasing the rich and the poor gap in the rural economy. Also, the lack of proper financial solution is acting as a major hindrance for further improving the standard of living of rural India.
Also, during the course of unexpected circumstances like illness, death, accident etc, this sect of population remains helpless without any viable financial solution. Thus, financial inclusion, majorly targeting this sector of Indian economy is very important for improving their standard of living. also provides banks with fresh funds which can be further invested in building the infrastructure in the society. Therefore, financial inclusion will lead to a win-win situation both for the rural sector and the banking industry.
This sector earns wages on a daily basis or rather on a weekly basis. They will look for an uncomplicated financial solution that can give them quick access to their meager savings. It should also involve less paper work. Also, the financial product should enable this sector to build their assets and reduce their risk levels. Banking industry must tailor their products on these lines. The current penetration of banking sectors in rural India is very low. Life Insurance penetration hovers at less than 5%, equity market penetration is less than 10% and fewer than 60% of households have access to banking services. And, the current size of microfinance accounts is 21 million (Source: M-Cril Microfinance Review 2012). Therefore, there lies an immense opportunity for the banking industry as well as there are 500000 villages which are yet to be provided with a formal banking channel.
However, of late this industry has been in severe turbulence due to various reasons. Before understanding the reasons for this turbulence, a glimpse of current industry scenario is presented below:

Southern part of India has been the major hub for MFIs since 2003. However, due to the recent SKS crisis, there has been a variation in this ratio.
Source: M-Cril Microfinance Review 2012

Recent fall of SKS Microfinance has been a major setback for the industry. Also, excessive loan provision in the state of Andhra Pradesh and atrocious methods adopted for collecting the money back reduced the cost efficiency to a significant extent.
Source: M-Cril Microfinance Review 2012.
The average yield of the industry is lower than the global median of 28%. This is expected to fall further because of the caps for microfinance NBFCs. MFIs in India have the worst portfolio quality ratio in the world.

It can generate millions of well paying jobs and more importantly have an enormous multiplier effect on inclusion and economic growth. It also hedges them against inflation. Financial inclusion encourages poor people to save and bring them into formal financial intermediation system and channel them into investment. These investments can be used in the projects with greater return on investment than what could be invested by poor people and sharing the profit with them. Moreover, large number of low cost deposits would reduce the dependability of banks on bulk deposits and help them to manage their liquidity risks and asset liability match efficiently.
Poor people would also get protection against the informal sources of credit like money lenders, Ponzi and Pyramid schemes etc., which is widely prevalent in the poorer region.
It has also been seen that there is a relationship between unemployment rate and the financial exclusion.1 It reduces the prevailing unemployment rate and therefore help people improve their lives. Apart from this it has ability to tackle poverty and inequality as it empowers people to save where they can get interest which is equivalent to market rates, which in long run bring prosperity to the people.

The story does not end here. Although there are numerous benefits of financial inclusion but it is very important to discuss the hindrances which have led to toppling of microfinance industry as a whole and the problems which deter its successful implementation.
The challenges can be divided into two types: demand side and supply side. On the demand, there is lack of awareness about financial services and products, which prevent the spread of even services suitable for poor people. Lack of financial literacy and social exclusion also lead to either people choosing wrong product or even abandoning the services. It has also been observed that many of the products are not suitable to their needs and neither any attempt is being made to do so.
The unfriendly and unempathetic behavior of employees in the bank has lead to decrease in demand of products and services. On top of that, exorbitant and oftentimes non-transparent fees, combined with burdensome terms and conditions attached to the financial products, also dampens the demand.2
Source: SaDhan, 2012. The Bharat Microfinance Quick Report 2011. New Delhi: SaDhan.
The figure above shows the low level of penetration in some of the states

From the Supply Side, the three big challenges are: (i) cost; (ii) lack of robust technology; and (iii) lack of awareness. Transaction costs are high in the case of Microfinance. Because of current low volumes, banks find that extending financial services is not cost effective. Furthermore, lack of communication, lack of infrastructure, language barriers and low literacy levels all raise the cost of providing services and inhibit bankers from taking initiative from the supply side. Also, there has been less attempt made to tailor the products according to the needs of the target customers.
Even in existing microfinance institution, there were some drawbacks like moral hazards and large systematic problem. An example of this can be found in Andhra Pradesh where the banks made multiple loans to the already debt ridden borrowers. The Andhra Pradesh experience shows us that centralization and standardization, leads to gap between the products available and the requirement of people targeted. Also, involving private sector under unregulated environment has resulted in Microfinance crisis.


From, the AP experience we can summarize that the success of financial inclusion requires an approach that is localized and dependent on customization of products and services under proper regulation, rather than the present approach that attempts to centralize and standardize the whole process. RBI is playing an active role in this direction. Not only the government and the RBI, but also private banking players should proactively participate in financial inclusion. A recent effort of the government to open an exclusive bank for women is also rightly targeted in this direction. Also, the government must ensure that the poor not only have accounts but also sufficient amount in that account for their sustenance.

Raghuram Rajan Report on Financial Sector Reform

Soumya Chanduri (12PGP097)
Anupriya (12PGP063)

1 comment:

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    Nice & informative information.
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