Economic and Political Weekly July 28, 2007 mergers and consolidation, suggested use of correspondents, appear to be incremental and ad hoc; not a well designed and thought-out response to the problems faced by the rural areas. This lack of planning of a rural financial architecture and its linkage with the rest of the financial sector is at the core of the problems currently affecting the rural areas. This policy gap has resulted in tardy progress in financial inclusion and affected the quality of services. The speed of conversion of public sector banks into widely-held companies answerable to shareholders has not been matched by generation of alternatives in rural finance. Business lines that are less profitable cannot be expected to remain a priority of a shareholder-run commercial banking system.

At the country level, ensuring access to at least one member of each family for banking services would mean 200 million clients for the banking system. As against this, the number of loan accounts with the banking system is an estimated 125 million. If we expand the definition of financial inclusion to “providing access to all adult members of the population”, at the least the number of potential clients to be serviced would increase to about 600 million. All commercial banks put together carry 466 million deposit accounts in their books. There is a large gap between the number of potential and actual clients with the banking system.

India had invested considerable resources in expanding its banking network. More than 60,000 branches of commercial banks and more than 1,00,000 primary agricultural credit societies (PACS) functioning as extended arms of cooperative banks and over 2,000 primary urban banks serve the people of the country, apart from several other formal financial institutions, big and small. This large infrastructure that has penetrated even remote rural areas is still able to serve only a small part of the potential clientele. If the potential clientele has to be served, even with minimal access, it is clear that the present infrastructure would not be sufficient. Firstly, the physical infrastructure would be a limitation in expanding the number of clients. Secondly, the staff required to deal with the expanded client base would be inadequate.

An analysis of the data relating to number of deposit accounts and loan accounts statewise captures the challenges in achieving financial inclusion. An attempt has been made to relate the number of deposit accounts and loan accounts of the scheduled commercial banks (which account for more than 85 per cent of total banking business in the country) with the census data pertaining to the year 2000-01. Across the country, as against 193.6 million households, 466.7 million deposit accounts are held with the commercial banks. On the surface, the data indicates that each household has more than two deposit accounts with the commercial banks (not reckoning the accounts that may be held with the cooperative banks). However, loan accounts were only 77.2 million in March 2005 indicating that about two out of five households had access to a loan facility from commercial banks. But these averages seem exaggerated once we recognise that a financial service is rendered to an individual and not to a household. Further an analysis of the statewise information reveals the disparity in coverage of financial services. Loan coverage: If we assume that financial inclusion would stand achieved when every adult has at least one deposit account, then we find that in 20 states, inclusion is yet to be achieved. There are 10 states in which more than half the adult population does not have a deposit account. In the case of loans, the position is even worse. The state with the best loan coverage (Tamil Nadu), reports that only one out of

every three adults enjoys a loan facility with a commercial bank (since the analysis is made on the basis of number of loan accounts, the possibility of multiple loans in the same name reducing coverage further has not been factored in). There are 15 states in which less than one in 10 adults has a loan account. This includes some of the larger states such as, Rajasthan, UP, Bihar, West Bengal, Jharkhand, Chhattisgarh, Madhya Pradesh and Gujarat. At the all-India level, only 13 per cent of the adult population enjoy a loan facility and 77 per cent have a deposit account. In the case of loans, even if we include the 45 million borrowers banking with the cooperatives, we find that against 600 million adults, hardly 122 million loan accounts exist. Branch network: The inferences from the foregoing analysis point to the challenges facing financial inclusion. Any effort or inclusion calls for extraordinary efforts. At a conservative estimate, a 400 per cent increase over the present number of accounts in the case of loans and a 50 per cent increase over the present number of deposit accounts may be needed. The financial infrastructure established in the rural areas as it stands today is not adequate to undertake this effort. A look at the load per branch in terms of deposit accounts and loan accounts provides certain pointers. The all-India average of deposit accounts per branch is around 6,500 and the loan accounts are around 1,100. The range across states in the case of deposit accounts per

Himal

Economic and Political Weekly July 28, 2007

branch is from a minimum of 2,038 in Mizoram to a maximum of 9,000 in Pondicherry (Table 3). The average per branch number of loan accounts ranges from a minimum of 500 in Meghalaya to a maximum of 2,500 in Tamil Nadu. Eleven states have deposit accounts per branch above all-India average. In the case of loans, 21 states have per branch loan account below the all-India average.

Assuming all the branches in the country could reach the best state’s average, calculations show that in the case of deposit accounts, we would still require 140 million more accounts to cover the unserved adults and 460 million more loan accounts to cover people unserved for want of branch network. While in the case of deposit accounts, it might be possible through incremental measures to bridge the gap, in the case of loan accounts, incremental measures may not be sufficient. Banks have to step up to a higher scale of operations by expanding their rural branch network. Certainly, this calls for a reversal of the trends seen in the recent years – that of closure of a number of rural branches by commercial banks. Such an expansion would entail significant additional costs. To ensure profitable rural operations in the face of additional costs, banks have to invest in radical innovations that would make branchless banking feasible. Know your clients: The aspect of costs (of both institutions and the clients) in expanding access to financial services needs some analysis. The rigour of know your client (KYC) norms, the need for diligent bookkeeping and the criticality of maintaining high standards of services would entail significant costs to the banks. As a proportion of business, these transaction costs are bound to be high in the case of small clients. Ideally, the banks should be permitted to price their products to ensure full cost recovery. Universal access: If the banks determine their prices on the basis of full cost recovery, would a typical client in the unorganised sector afford this kind of cost? The answer in most cases would be a clear no. In fact, banks have been using certain features such as a minimum balance in savings accounts, fees of different kinds in the case of loan accounts that would cover the overhead costs, a limitation of number of operations on smaller accounts, etc, as means of keeping costs under control. These practices result in hidden costs to the client. The RBI brought in the concept of “no frills” account to ensure that the clients do not have to pay hidden costs so that the clients’ costs of accessing services are affordable. When clients’ costs are set at affordable levels, banks would tend to limit the number of such clients; as at the end of the day, they have to post profits. What is clear is that there is an inherent conflict between the banks and their small clients in the matter of who will bear the costs of access to financial services. A solution needs to be found if universal access to financial services has to become a reality.

Currently, the debate on costs is limited to the expansion possibilities of banks at their current scale of operation. But if the entire unorganised sector population has to be linked to the banking system, the banks will have to scale up their operations, and increase their capacity by two to three times. This scaling up effort would involve significant investment costs as well which would have to be recovered. These costs, if passed on to the small clients could make their access to banks even more difficult.

Thus an introduction of universal access to financial services is not likely to be easy. This calls for certain decisions in the domain of public policy. Banks are being called upon to provide financial services to all types and manners of clients on lines similar to post office under “universal services obligation”. Recognising that financial infrastructure is a “public good”, both the RBI and the government of India should invest in creating the financial infrastructure required for access to financial services by one and all. This could be in the form of reimbursing capital investments of banks in expansion or an annual payment out of a Universal Service Obligation fund in proportion to the additional clientele covered from the unorganised sector. This would make the cost of access affordable to both the bankers and the clients. Financial inclusion as a public policy objective is meaningful only when costs of increasing outreach are borne in the initial period by the state.

While structural solutions are expensive, and nevertheless must be pursued, should not banks think of designing a process response to the problem? Banks achieved considerable progress in financial inclusion of large numbers cost effectively under the SHG bank linkage programme. An estimated 33 million households have been provided access to banks over the last 10 years, with a major part of the effort

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Economic and Political Weekly July 28, 2007

being made in the last four years. Such process-solutions enable banks to cost effectively reach the unorganised sector. There is a need to look more deeply into group-based methodologies so that local communities participate in banking, absorb a part of the costs, eliminating the much-maligned bank charges.

Identifying new clients and bringing them to banks is the dominant content of financial inclusion initiatives. Here, apart from costs, staff capacities are also involved. The tasks of (a) identification of new clients, (b) enabling them to fulfil KYC norms, and (c) certification of the clients and banks’ compliance with KYC norms, could be outsourced to third party service providers. Such an agency could be an alliance of SHGs, or a mechanism set up by the panchayati raj institutions (PRIs) or any other credible source that could gather data, present it in a form suitable for the banks and certify the accuracy and veracity of the information. Such agencies have the potential of becoming credit information bureaus over a period of time that could be networked into a national level credit information exchange. Risk management: Defaults are inherent in banking business. Banking is all about identifying the risk, quantifying the same, designing a mitigation mechanism and pricing the product in such a manner that the risks are absorbed across the portfolio. Bankers have received periodic reminders of the fact that large loans are equally at risk and such large risks singularly affect banks. Financing a variety of activities under the unorganised sector could, in fact, be a very appropriate risk diversification mechanism.

Risk management practices in financing the unorganised sector have been predictably traditional. The measures consist of either asking for increased collateral that the borrower in the sector could ill-afford to bring, or ask for an increased own stake which s/he does not have. Otherwise, banks look for a subsidy scheme under which the borrower could be financed. Lastly, an increased interest rate to absorb the higher risk costs of dealing with this sector is applied to mitigate risks. Most of these conventional approaches would tend to exclude deserving customers and attract the desperate borrower who in most cases does not intend to repay. The group approach to lending to small borrowers has shown over the last few years that there are alternatives to conventional approaches to dealing with this sector. Cash flow-based lending approaches also hold out much promise of risk reduction as they reduce the need for dependence on external sources of funds for other productive purposes.

Innovation and Creativity

This is not to suggest that banks do not finance the marginalised and underserved people. There are a variety of governmentsupported, funded and subsidised programmes under which banks have lent a lot of money, albeit reluctantly. There are also initiatives like the SHG linkage programme under which banks have lent large sums voluntarily. These have proved that the unorganised sector is a commercial proposition for the banks; what we needed are product and process innovations that could effectively deal with the large number of small financial needs.

Innovation and creativity are the key words in the future of banking in general and in the coverage of clients that have not been served so far. The unorganised sector has been financed for a long time by traditional players – another set of unorganised people – with success. The village moneylender, landlord, petty trader, commission agent, input supplier, commodity procurer and a host of others with different role descriptions and functions, have been the backbone of unorganised sector. If many such players could do something successfully for a long time, why banks with professional expertise and financial strength could not do the same? The ideas on how to cover the rest of the unorganised sector and with profits should be drawn from the unorganised financiers. From there one could redesign products and delivery mechanisms that could increase the comfort level of bankers and bring such clients to banks. The task of servicing the unorganised sector could be outsourced to market intermediaries.

The market intermediaries are best placed to handle the outsourced work, as their knowledge of the local area, local economy and people is wide and deep. We should think of legitimising such market intermediaries to play a financial intermediary role, with or without risk participation. The RBI’s internal working group on microfinance has already spawned a few new ideas including use of franchisees, facilitators and banking correspondents. With the central bank adopting a positive and proactive stance for improving outreach of financial services to marginalised people and its recent focus on financial inclusion it should find ways of changing the current banking paradigm on unorganised sector.

The financially excluded are not an easy business prospect in waiting, just to be plucked. Many of these potential clients have to improve their capacities, before entering commercial activities. The issue is not merely of finance, with a finite banking solution. There are other facets, which need attention from the governments and community organisations. Creating opportunities for unorganised entrepreneurs to thrive through a facilitative policy framework falls in the domain of governments. Enterprise risk mitigation and management is another major aspect requiring attention. Provision of fair markets and access to markets through a combination of physical infrastructure and capacity-building is also a priority. The market is a hard place that has no gentle feelings for the unorganised sector or weaker sections in general. Non-governmental organisations (NGOs) have a particularly difficult role of preparing the budding entrepreneurs from the sector to compete in a market-oriented economy. Training bankers and influencing mindsets to look at the unorganised sector from a new perspective is the job of training institutions buttressed by senior management of banks.

Financial inclusion should not remain a daydream of a welfare state. It is a necessity if the country has to realise its economic potential. The country cannot afford to have an elite minority enjoying services with banks and a large unorganised majority in the cash and barter mode. This divide, apart from undermining economic growth could engender social tensions. Sustained growth of the nation and its continued prosperity depend critically on universal financial services coverage of all people. Banks are in a unique position to make the transition from a “cash market” to a payment system-driven economy and profit in the process.

EPW

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