ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Inclusive Financial Systems

Besides facilitating overall economic growth, finance can help individuals smooth their income, insure themselves against risks and broaden investment opportunities. Empirical evidence shows that inclusive financial systems significantly raise growth, alleviate poverty and expand economic opportunity. This paper lays out several principles that should be kept in mind when designing such systems, supported by a case study of ICICI Bank.

Inclusive Financial Systems

Some Design Principles and a Case Study


Economic and Political WeeklyMarch 31, 20071122Advt Page
Economic and Political WeeklyMarch 31, 20071123credit, insurance (including life, accident, health, weather)givenhis/her particular requirement. A focus on credit alone might notfully addressthe household’s risk management and consumptionrequirements.In the landscape of providing access to financial services topoor households, twodistinct but complementary models haveemerged. One in which the managerial aspects related to suchaccess is the responsibility of a specialised service provider, saya NBFC or a cooperative bank, and another in which thisresponsibility is assumed by the users/community themselves,as in the SHG models where groups take responsibility foraccounting and book-keeping.Each model of financial servicesdelivery has its own unique strengths; however,clients must havea choice between the two. Policy-makers must not assumethatmanagerial responsibilities are easy to assume and dischargeor that low-incomehouseholds are eager to do so in every in-stance. This is particularly the casefor households with com-peting demands for time as is the case with urban low-incomehouseholds. Specialised service providers provide this manage-rial abilityin return for a fee. Clients must be free to choosebetween paying that fee to anexternal provider or internalisingthese managerial costs themselves through self-organisation intogroups of various kinds. In either case, the important point isthatthese costs exist. The fact that communities internalise themdoes not mean thatthey go unreckoned. In addition, there is alsoa concern about viewing community groups as permanent entities.Even if we concede that a group can mange a savings or creditoperation in perpetuity, this approach is not flexible to accom-modate the evolving financial service needs of the underlyingmembers – be it larger loan sizes, individual liability loans ornew products such as insurance and derivatives. Once again thepoint being made here is that the choice of format to accessfinancial services must be left to the customer at all points intime and there should be no attempt in the design to hard-codea particular format in which delivery is possible.Specifically in the case of credit, individuals unable to offercollateral must be able to systematically build and “port” theircredit history across financial service providers. Helping the poordevelop credit histories and centralising credit histories makecredit markets less segmented and therefore, borrowers haveaccess to cheapest sources of credit.5Regulator PerspectiveThe preceding discussion seeks to make the point that the finalconfiguration of how access to finance is created is dynamic andmust be informed by previous experiences in this regard. Theoutcomes that regulators should care about are (a) whether accessto financial services is universal, (b) whether such access is ofa quality that is acceptable (here, quality is used to cover aspectssuch as the lender-borrower relationship and features of financialservices offered) and (c) whether providers are sustainable andmeet certain governance norms. Regulation must not favour oneor the other model for reasons beyond the above, i e, regulatorsmust be outcome-driven and model-neutral. Historically, certaininstitutional designs have been supported with a view toincreasingfinancial inclusion. For example, cooperative banks and regionalrural banks were created with this mandate. The primacy of thismandate has often meant that other metrics such as capitaladequacy have not been used to evaluate these institutions andthese entities have been recapitalised on occasions. Despite thesesubstantive concessions, they have not delivered on the objectiveof financial inclusion. This experience shows us that financialinclusion cannot be achieved merely by diluting designprinciples.On the contrary, that may impede the emergence of other modelswith the potential to address the challenge of financial inclusion.The regulator has been concerned that lowering the entry levelcapital requirement in order to obtain banking and NBFC licencesmight lead to proliferation of entities. The concern is with ref-erence to the regulatory capacity being a limiting factor – if “toomany” underlying regulated institutions are created, then thesupervision responsibilities on the regulator may become un-sustainable.6Implicitly, the minimum capital norm is also meantto be a screening device for quality of financial service providers.One pragmatic alternative that reconciles this trade-off betweenfinancial access and supervision load is to consider models suchas the partnership model (for credit) and business correspondent(for savings) that rely on already regulated entities extending theiroutreach through third parties. Where entities desire to warehouserisk on their own balance sheet, they would have to be inconformityto the minimum capital norms specified by the central bank.7IIWhat Have We Learnt about‘What Does Not Work’?Attempts to impose interest rate caps have resulted in eitherdistortion of pricing by providers or withdrawal of lenders therebyhurting rather than aiding improving access to finance.8Deposit-Taking by Poorly Capitalised andNarrowly Diversified EntitiesGiven the experiences of a variety of service providers on theground, there would be real concern if, particularly for the poor,poorly capitalised entities are permitted to warehouse risk on theirbalance sheet. The points of failure could be multiple:(1)Use of savings for on-lending into the same geography exposesclient savings to systemic risk in the region. This approach doesnot leverage benefits of national diversification to provide se-curity and liquidity to client savings. This concern is applicableto a wide class of service providers: (a) non-bank finance com-panies; (b) cooperative banks; (c) regional rural banks; and(d)SHGs that collect savings and use them for on-lending directlyor as collateral in some form. For example, people in a regionmight be saving in order to build protection against rainfallfailures. In a model in which deposits from these individuals arere-deployed as loans in the same geography, rainfall failure mightimply loan riskiness and therefore, inability of savers to usedeposits when they need it the most.(2) As a consequence of the above, narrowly operating entitiestypically have to offerhigher rates of interest to attract depositors.This in turn forces them to chargehigher rates on loans. Thisgives rise to the concern that the loan portfolio over timewillsuffer from the problem of adverse selection – those who arewilling to borrowat higher rates may be “riskier” thereby af-fecting the security of depositors in the sameentity.(3) An entity that accepts deposits in addition to a lending functionmust be able tomanage the inherent asset-liability managementissues and liquidity risks. Thisentails the ability to invest inautomation and information systems that can supportthese func-tions, which is typically not the case with small entities.
Economic and Political WeeklyMarch 31, 20071124Advt PAge
Economic and Political WeeklyMarch 31, 20071125(4) Additionally, lack of access to instruments such as creditderivatives impairs the abilityof these entities to manage creditrisk through strategies other than diversification inorigination.This in turn is challenging for entities that by design operate innarrowgeographies.Governments investing in creating systemic infrastructure areseen to facilitate other providers to work in these markets. Thissystemic infrastructure could take the form of national identi-fication numbers, credit registries, payment systems, electroniccommodity and auction markets and weather measurement sta-tions that are in the nature of public goods and stimulate marketactivity. This is superior to more “interventionist approaches”such as the government being a provider of subsidised financialservices.9IIIICICI Bank Case StudyWhile these design principles may be consistent with manyon-ground configurations pursued by other institutions, ICICIBank has chosen the following:(1) ICICI Bank and its group companies are to be the providersof deposit taking and insurance services and therefore theywarehouse all the attendant risks. Since as on June 30, 2006 itsassets are $ 60 billion, its networth exceeds $ 5 billionand its rating is AAA, it is in a good position to absorb theserisks. As on date, ICICI Bank has built a portfolio exceedingRs16,000 crore in rural finance of whichRs 2,500 crore is tolow-income families and has a customer base exceeding 2.5millionclients.(2) To develop a relationship with a network of local institutions(both urban and rural), which could be cooperative banks, pro-ducer cooperatives,NBFCsand not-for-profit civil societyorganisations to actually distribute these services. A combinationof these partner institutions, rural hub branches at a cluster leveland agents (such as tractor dealers) appointed by the bank rep-resent the core of its “no white spaces” strategy that aims to cover200 districts by 2007. Under this strategy, the bank plans to haveat least one touch point (collectively referred to as ICICI Bank‘grameen kendras’ which may belong to ICICI Bank or itspartners) every three to five kilometres in rural and semi-urbanareas [Iyer 2006]. If the model succeeds this impliesthat thenumber of ICICI Bank grameen kendras capable of offering areasonablycomplete suite of financial services would exceed50,000 (or 1 for every 10 to 12 villages) by March 2007 andthecustomer base could exceed 25 million by 2010 [Anand 2006].(3) To use the “partnership model” for the lending business inorder to build incentive compatibility with the local institutionthat is delivering this specific financial service. This design drawson the separation of functions discussion in the preceding section.The partnership model leverages the local information and coststructure of a localfinancial institution in order to unlock thefinancing ability latent in the commercial banking sector. Themodel has been designed with the feature of the local institutionsharing the risk with the bank so that there is careful originationand supervision on anongoing basis.10(4) For deposit taking work with a variety of local institutionsto provide these servicesunderthe business correspondentmodel.11 Business correspondents are agentsidentified by thebank to provide basic banking services such as opening bankaccounts, collecting savings and deposits and offering insuranceproducts in rural areas. ICICI Bank takes full responsibility forits correspondent’s business conduct. The bank has alreadylaunched this service in Orissa and Andhra Pradesh.12(5) Similarly in insurance, ICICI Bank and its group companiesICICI Prudential Life Insurance Company and ICICI LombardGeneral Insurance Company work with local institutions fordesign and delivery of insurance products – under thebancassurance model these policies will be sold at the ICICI Bankgrameen kendras. Given the peculiar challenges of health insur-ance delivery, it has worked with hospital networks and third-party administrators to coordinate quality of healthcare as well.(6) In order to facilitate better price discovery and price riskmanagement for farmers,ICICI Bank co-promoted the NationalCommodity and Derivates Exchange (NCDEX) jointly withNational Bank for Agriculture and Rural Development(NABARD), the National Stock Exchange (NSE) and LifeInsurance Corporation (LIC). NCDEX along with its affiliateNational Commodities Management Services Limited (NCMSL)is attempting to improve access to price derivatives for farmers,facilitate commodity-based finance through banks, provide weatherstations and improve the warehousing infrastructure.13(7) For its work in product development, ICICI Bank has com-bined its expertise in financial engineering with the insightsgenerated by its partners and allied research institutions. To date,ICICI Bank and its group companies have designed and are takingto scale products including the following: (a)index-based rainfallinsurance; (b) catastrophic health insurance; (c) working capitalfacilities for agriculture traders; (d) working capitalfacilities forcrafts people and artisans; (e) take-out finance for start-up localfinancial institutions; (f) warehouse receipt based financing;(g)credit to low-income households through the partnershipmodel; and (h) savings to low income households through bankingcorrespondent model.(8)It is ICICI Bank’s belief that in order to improve efficienciesin financial intermediation, especially in the context of smallunsecured loans, the role of technology is crucial. ICICI Bank’sinitiatives in technology may be broadly thought of in twocategories: (1) Front-end technology investments – this includesissuance of smart cards with unique identifiers to its clients thathelp the client track financial services usage data on a real-timebasis as well as sharing of credit information across ICICI Bank’snetwork. (2) Back-end technology investments – this relates toinvestment in creating better core banking systems among itspartner institutions. This enables more efficient data capture andsharing and reduces margin of error on transactions. ICICI Bankhas collaborated with FINO, a company that seeks to providefront-end (smart card, point-of-sale terminals), back-end(bankingsoftware, performance management and reporting, MIS) andinformation services (credit bureau) to community-basedfinancialinstitutions14and is now looking to partner withNABARD, StateBank of India and the Credit Information Bureau of India Limitedto try and see if FINO could, as in the case of NCDEX, becomea provider of these technology services on a system-wide basisparticularly to cooperative banks and NBFCs engaged in thebusiness of lending to and collecting savings from small borro-wers. The participation of the RBI and NABARD in some ofthese initiatives that have a systemic benefit would be an accele-rator of access to finance.(9) ICICI Bank is conscious that working in rural India and withpoor households is fairly uncharted territory. It has tried to baseits growth strategies on systematic results of what works at the

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