The Raghuram Rajan Report – A closer look at financial inclusion

The Raghuram Rajan Committee on Financial Sector Reform has placed its draft recommendations in the public domain for comments. I would like to focus on the chapter on financial inclusion. Full disclosure – I worked with the committee to support this part of the report. Also, I run a midsized urban microfinance institution (MFI). My views are therefore neither objective nor unbiased.

While the report makes several recommendations to improve financial inclusion - the use of technology, embrace of distribution channels like kirana stores, leveraging post offices, deeper penetration of the banking correspondent model, a tradable system for priority sector credits, a new model of small finance banks – there is an overarching theme that encompasses these diverse ideas. This theme is of an “inclusive finance ecosystem”, where multiple players are constantly innovating in delivering financial services to the poor – better products, improved business processes to lower costs and risks, and technologies that enable these.

Mythili Busnurmath wrote about the Rajan report in The Economic Times, “It is increasingly becoming apparent that the benefits of competition and even of greater financial inclusion can be better achieved by bigger-sized banks that enjoy both economies of scale and have access to cutting-edge technology solutions.” I’m not sure that the data on financial inclusion supports this view. More importantly, I don’t think that the large firms would be the ones driving innovation in a financial inclusion ecosystem.

Innovation is almost always driven by entrepreneurs. In the financial inclusion arena, these entrepreneurs come in two breeds: either those driven by the incentive of wealth creation or, as Muhammad Yunus said, social entrepreneurs who want to use market principles to address social problems.

As promoters of microfinance institutions (MFIs), entrepreneurs like Aloysius Fernandes and Vijay Mahajan have been at the forefront of innovation and risk-taking in bringing large numbers of the poor into the banking fold. Unfortunately, MFIs are trapped in a maze of schizophrenic regulations and confusing institutional structures, which offer few paths to scale and consistent innovation.

One solution is for MFIs to become scheduled banks. Unfortunately, the capital requirement for a commercial banking licence in India is Rs 300 crore. Data for the top 54 Indian MFIs available on an industry website called Mixmarkets (www.mixmarkets.com) shows that their total equity base was a shade under Rs 300 crore as of March 2007 – i.e., they couldn’t get a single banking licence even if they merged their businesses.

The increasing interest in microfinance would suggest that raising Rs 300 crore should not be a significant constraint for leading MFIs. There is little publicly-available information on investments into microfinance, but from sketchy data, it seems that a $25 million investment by Legatum in Share Microfin in 2007 got them a 51% stake in the firm. Applying the same valuation ratios for the top MFIs in the country suggests that they would have to give away anywhere between 75% to 95% of their firms to investors to raise enough capital for a banking licence. Even assuming that MFIs could actually raise this kind of capital, given their limited product offerings/ management structures/internal systems, I can’t think of many promoters willing to become minority shareholders to such an extent. So the issue is not the entrepreneur or the investment climate – it’s that the capital requirement bar is simply too high.

The Rajan report recommends the creation of Small Finance Banks (SFBs), under a common regulatory umbrella with the mainstream banking system. The recommendations are for very high requirements of corporate governance, transparency and other operating criteria. Importantly, capital adequacy requirements could be based on risk measures that result in higher capital ratios than currently applicable for commercial banks, rather than absolute thresholds of capital.

In his comments on this recommendation of the Rajan report, Shankar Acharya states, “I wonder if (the report) may have underestimated the enormous regulatory challenges involved, especially in a multi(in dozens!)-party federation with declining governance standards”. No question that there are large regulatory threads to untangle. The baggage of unsuccessful experiments of the past – urban cooperative banks or local area banks - doesn’t mean that the model is wrong, just that the operating environment needs to be different.

The idea of an inclusive finance ecosystem is one worth debating - of big and small institutions working to expand the range of financial services available to the poor, sometimes in competition, but more often in partnership. If this idea holds merit, small finance banks could be the innovation flywheel to keep such an ecosystem vibrant.

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The author is Co-Founder of Janaagraha.