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The RBI’s mandate-driven approach has constricted financial inclusion.

Updated: January 14, 2014 4:26 am
The incumbent banks feel little or no pressure to reach out to unbanked areas and people. This, in turn, necessitates a mandate-driven approach to financial inclusion.  Reuters The incumbent banks feel little or no pressure to reach out to unbanked areas and people. This, in turn, necessitates a mandate-driven approach to financial inclusion. Reuters

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.

The writer, RBI Chair

Professor at the NIPFP, Delhi, is a consulting editor for ‘The Indian Express’ and non-resident scholar at the Carnegie Endowment for International Peace. 


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  1. prakaash Joshi
    Jan 14, 2014 at 11:49 pm
    The author is absolutely correct. RBI/Banks approach in traditional way. No new ideas or approach. We need to think about quantum jump with help of technology. Why not have a virtual mobile Bank for this purpose. The delivery model is possible. Using 4 G connectivity will be possible. This may take few years but thinking has to be out of BOX.Not only Banking and ATMs , but all financial services can be made available through mobile Bank.
    1. H
      H.K. Satija
      Jan 15, 2014 at 8:40 am
      I fully agree that increased compeion 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. The new entrants in both the Banking and insurance sector be financially sound and initially Insurance regulatory authority and RBi may keep a close watch on them for sometime till they have proved their mettle.
      1. P
        Jan 15, 2014 at 12:32 pm
        To cut cost, only one bank branch should be there in one area. Now we find some 10 Bank Branches doing the same this the same area e.g.Sai Nagar. And even in the City and Town the Public Sector Banks do not have any initiative in inclusive growth. They lent Loan to only Property Dealers, who lock up the resource and speculate with LUXURY Homes and Malls or rather Build and Speculate with Unsellable Properties.
        1. S
          Jan 15, 2014 at 1:48 pm
          1) If 25 top banks cant achieve financial inclusion, do you really think 5 more will achieve it. 2) Banks like SBI and ICICI has more than 243 product portfolio, and you say about innovations in product and services. The question is of marketing the product.Branches are currently dealing with huge shortage of man power and loans like SME, Agriculture needs training and dedicated channels which can only be provided through skilled and experienced people, less paper work, encouraging paperless banking, streamlining various laws which are so different at state to state level. 3) Many projects that bank finances are blocked by archaic laws, govt department, complex tax regime. Business promotion in india is not good. If a group of engineers or agriculture graduates want to start a cold storage and bank finances through collateral free or govt schemes, the project gets stuck due to many regulatory issue.4)Bank should focus more on their core aspect of lending and deposit, quality and maintenance of ets, providing people with fast and speedy transactions. Rather than capital intensive mutual funds , insurance and discriminating people for loans on basis of this.5)BC and BF has ran banks into trouble because proper identification and tracking of these people are not in place. Many frauds have emerged at the ground level because of these agents. As no accountability on these agents can be fixed.6) Banks are overburdened with lots of stuff that consumes man hour , and hence they just cant focus there energy on core issues, of gaining expertise in lending.7) Perhaps RBI believes that only opening a branch will result into development. But if you cant improve law and order , cant provide roads, electricity, internet, streamline taxation system, Single identification system, skill development, Basic financial education at schools bot rural and urban, financial inclusion will be a distant dream.
          1. S
            Jan 15, 2014 at 2:04 pm
            Great Observation Proper town planning both rural and urban are not there. If one PSB opens a bank at a place where potion is less than 50000. Many Private sectors come and open branches after seeing and spying that branches can make profit, result a small place has 5 branches poaching each other rather than competing and netting people for more accounts and business. This may improve services but results into focus on local wealthy people rather than branching out for more coverage.Financial inclusions can be brought by scholarly insights with jargons like innovations , compeion, fair playing ground,etc. We need to plan position and type of branches keeping view of the available infrastructure in that area so that branch can run with less hiccups.
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