Same old banking

Indian Express, 14nd January 2014

The RBI's mandate-driven approach has constricted financial inclusion

A Reserve Bank of India panel has submitted a report on financial inclusion. It proposes that priority sector lending by banks be raised and that banks be mandated to open accounts for every adult Indian by January 2016. The recommendations do not challenge the RBI's basic approach to financial inclusion. This approach, which has been to mandate banks to undertake financial inclusion, might have spread public sector bank branches in rural areas for some years, helped open bank accounts and directed credit, but it has stopped yielding results. What India needs is a new approach, which encourages competition and innovation, rather than more mandates.

India's approach to financial inclusion has been bank-centric. So far, it has focused on bank nationalisation, continued with government ownership of banks and their recapitalisation. The way to ensure inclusion has been priority sector lending, which mandates that 40 per cent of each bank's lending be to weaker sectors - small-scale industries, agriculture and exports - to which the bank might not have lent otherwise. The RBI panel now recommends raising this share to 50 per cent.

The panel's recommendations are in sync with the RBI's recent guidelines for the grant of licences to new banks. These require that the bank have a plan for financial inclusion and that it open 25 per cent of its branches in unbanked rural areas. This approach is similar to the one that required PSU banks to open rural branches. By once again mandating financial inclusion, this time for private sector licence applications, instead of focusing on competition and innovation, the RBI is essentially doing more of the same.

Financial inclusion may be defined as access to a range of financial services in a convenient, flexible, reliable and continuous manner from formal, regulated financial institutions. Even though access can be ensured by mandates, the quality parameters of access may be compromised in the process. This is seen in the low usage of accounts and the poor asset quality of priority sector portfolios. Such inclusion confuses ends with means. A bank account is meant to fulfil certain functions - simply opening an account is not enough. The panel proposes to make it mandatory for every Indian over the age of 18 to have a bank account.

An often overlooked consequence of the mandate-driven approach to inclusion, as pursued by the RBI, is that the costs of this inclusion are levied on the investors and consumers of banks. The losses from unused bank accounts and poorly performing priority sector assets are eventually borne by the investors and consumers. If the political objective of opening bank accounts is to be met, or lending to certain sectors ensured, it should be transparent as a line item on the government's budget. Instead, it is done through a cross-subsidy that effectively makes other customers pay for the political goals of a government pushing its agenda through banks.

This approach has been accompanied by a neglect of the other drivers of inclusion - competition and innovation. In the last 11 years, the Indian economy has grown rapidly, but no banking licences have been given in this time. The trend has been that once a decade, the RBI decides to give a few licences, but there is no window to get licences during this period. The incumbent banks feel little or no pressure to reach out to unbanked areas and people with their services. This, in turn, necessitates a mandate-driven approach to financial inclusion. Despite decades of RBI mandates, rural customers turn to informal channels and unregulated financial firms.

As part of the RBI's bank-centric approach, there are regulatory and entry barriers to prevent bank-like institutional mechanisms from competing with banks. For example, money market mutual funds, a viable alternative to bank deposits and popular in countries such as the US, are not allowed to issue cheques by the RBI, which also regulates the payments system. This reduces competition to banking. These barriers help generate complacency among banks and curb the extent to which new business models emerge.

The mandate-driven approach to financial inclusion has also been a key hindrance to innovation. The RBI has emphasised specific quantitative targets, such as priority sector lending or opening bank accounts. Lately, appointing customer service providers has been added. A consequence of these mandates is that the rural business departments of banks are too busy trying to meet the targets to spend time and effort in actual innovation that serves the consumers.

A comprehensive change in regulatory philosophy is required to bring about meaningful financial inclusion in India. This would entail a shift from the present bank-centric, mandate-driven approach to an emphasis on competition, innovation and consumer protection as the pillars of regulatory philosophy. The Financial Sector Legislative Reforms Commission has recommended an approach to financial regulation that is based on these three pillars.

To encourage competition, the RBI should not decide the optimal number of banks for the country. Bank licences should be available on tap, based on reasonable eligibility criteria. The RBI should also permit the emergence of new business models in banking, non-bank lending and payments. An increase in competition should encourage existing banks and newcomers to explore opportunities beyond the markets that have already been served.

The second pillar is allowing innovation to happen. The RBI's present approach prohibits innovation until it is expressly permitted. This approach has led to delayed innovation across all products and processes. For example, the business correspondent model, which enables the delivery of banking services through low cost agents, was introduced more than a decade after it made headway in comparable emerging markets. The RBI must shift to an approach that allows innovation to happen and then responds with proportionate regulations.

Increased competition and innovation must be accompanied by consumer protection, acknowledging the imperfections in financial markets. The idea of financial inclusion must not be limited to getting access. This access must help consumers use finance in beneficial ways, with the regulator protecting them from unfair contracts and terms.

Consumer protection also translates into proportionate regulation to maintain the safety and soundness of financial service providers. A bank or an insurance company must be managed prudently enough to minimise the probability of failure. The failure probability need not be zero, for that would lead to excessive conservatism. Once in a while, when a financial firm fails, it should be resolved in a manner that entails the least pain for the consumers.

India needs a new approach to financial innovation and it is time the RBI realised that more of its mandate-driven approach is not the solution.