Usha Thorat: Financial regulation and financial inclusion - working
together or at cross-purposes
Speech by Ms Usha Thorat, Deputy Governor of the Bank of India, at the Tenth Annual
International Seminar on Policy Challenges for the Financial Sector, co-hosted by the Board
of Governors of the Federal Reserve System, the International Monetary Fund and the World
Bank, Washington DC, 4 June 2010.
* * *
1. The case for financial inclusion is not based on the principle of equity alone -
access to affordable banking services is required for inclusive growth with stability. Achieving
financial inclusion in a country like India with a large and diverse population with significant
segments in rural and unorganised sectors requires a high level of penetration by the formal
financial system. Even in areas that are well covered by banks, there are sections of society
excluded from the banking system. Political and social stability also drive financial inclusion.
In the recent period, in countries like India, government has been encouraging opening of
bank accounts by providing government benefits through such accounts. ICT solutions have
made such initiatives possible at relatively low cost.
2. Financial inclusion is not merely providing reliable access to an efficient payments
system. Many discussions - especially in the context of mobile phone-led retail payments
system - seem to focus on this aspect of financial inclusion. Financial inclusion is also not
just micro finance. Financial inclusion represents reliable access to affordable savings, loans,
remittances and insurance services. We in India believe that financial inclusion primarily
implies access to a bank account backed by deposit insurance, access to affordable credit
and the payments system.
3. The key question is - What is the kind of regulatory and supervisory mechanism that
will ensure that the formal financial system delivers affordable financial services to the
excluded population with greater efficiency without compromising on acceptable levels of
safety and reliability?
4. Hence, in this session on financial inclusion and financial regulation, drawing from
the Indian experience, I am going to focus on the following issues:

Is there a trade off between financial inclusion and financial regulation - are they at
cross purposes or do they work in tandem?

What have been the various regulatory interventions in India to facilitate financial
inclusion?

What has been the approach to regulating non-bank intermediaries and entities
providing innovative and low cost solutions for financial inclusion?

What are the important consumer protection issues in the area of financial inclusion
and what has been the regulatory approach?
Financial regulation and financial inclusion - is there a trade off?
5. The last year was the platinum jubilee year of the Reserve Bank of India. As part of
the celebrations, several outreach activities were undertaken at remote unbanked areas.
During these visits, we were often asked by the people about "fly by night" operators who
had vanished with their life savings. The distress to people and the damage to public
confidence caused by such unscrupulous operators are something that no regulator can
ignore. Sound and reliable deposit taking entities, backed by deposit insurance for small
deposits, accessible to all are, therefore, essential for financial inclusion. It is not possible to
have sound and reliable deposit taking entities and a deposit insurance system without
financial regulation. Hence, in my mind, there is no doubt that financial regulation and
financial inclusion work together - the former is a must for the latter.
6. Another reason why there is convergence between financial regulation and financial
inclusion is that if financial intermediaries have to deliver affordable services they need to
take advantage of technology and economies of scale - this requires them to grow to some
optimal size. Such growth is not possible without capital. Investors and lenders are
comfortable with providing more funds only if such entities are regulated. This was our
experience with Micro Finance Institutions (MFIs) wanting to be registered as non-banking
financial companies with RBI, but wanted us to reduce the minimum capital requirement
below what we had prescribed for non banking financial companies in general. We allowed
them to register, on fulfilling the prescribed norms, without lowering the minimum capital
requirement. The dramatic growth of MFIs in the recent period on account of support by
lenders and investors owes in no small measure to their being registered with RBI as Non
Banking Financial Companies (NBFCs).
7. More recently, in the context of the global crisis, it is observed that undue reliance
on borrowed funds can be a source of risk and a more stable retail base of deposits is good
for both the bottom line and resilience. Similarly, a diversified asset portfolio lends to less
volatility in earnings. Thus financial inclusion which can promote such a retail and diversified
portfolio - in assets and liabilities - also promotes financial stability.
Regulatory interventions for facilitating financial inclusion
8. In this section, I would like to highlight the various regulatory measures taken by the
RBI to facilitate financial inclusion. The key message here is that the regulatory approach
has not compromised with prudential norms for deposit taking entities. We are of the firm
view that only sound and strong institutions can deliver financial inclusion. Within the overall
traditional prudential framework, what we have tried to do is to have a system of incentives
and disincentives that further the financial inclusion objective and while doing so, we have
tried to balance the degree of the risk with the ability to achieve greater penetration.
Is small beautiful?
9. Looking at the success of credit unions and community banks world-wide in
providing financial services to local communities, it could be argued that smaller regional
banks could be the answer for financial inclusion. However, our experience with local entities
such as cooperative banks, deposit taking non banking financial companies and regional
rural banks highlighted the risks of poor governance, connected lending, geographic
concentration leading to vulnerability to natural calamities and downturns. Small entities also
tend to absorb disproportionate share of supervisory resources. Besides, the adoption of ICT
solutions that are essential for accessing mainstream payments system requires larger
investments and these often prove to be too onerous for small entities and render them
uncompetitive. We have encouraged merger of non viable entities and growth of banks that
meet regulatory requirements. We have also followed a three tiered regulatory approach -
"non-Basel" approach for regional rural banks and rural cooperatives with the objective of
ensuring positive net worth, "Basel I" for urban cooperative banks and "Basel II" for
commercial banks. For non banking deposit taking entities, that don't enjoy deposit insurance
or offer savings/checking accounts, we have adopted a simpler regulatory framework albeit
with higher capital ratios.
Allowing banks to open accounts for Self Help Groups
10. An important regulatory dispensation that facilitated financial inclusion was given
in the early 90s, when banks were allowed to open savings accounts for Self Help
Groups (SHGs), which were neither registered nor regulated. An SHG is a group of 15 to
20 members from very low income families, usually women, which mobilises savings from
members and uses the pooled funds to give loans to those members who need them, with
the interest rates on deposits and loans being determined entirely by members. National
Bank for Agriculture and Rural Development (NABARD) launched the SHG-Bank Linkage
Program in 1992 to forge the synergies between formal financial system and informal
sectors. Under this programme, banks provide loans to the SHGs against group guarantee
and the quantum of loan could be several times the deposits placed by such SHGs with the
banks. The recovery rates of such loans have been good and banks have found that the
transaction cost of reaching the poor through SHGs is considerably lower as such cost is
borne by the SHG rather than the bank. Interest earned from group members is retained in
the group. The penetration achieved through SHGs has been very significant. As per
NABARD's report on status of microfinance (2008-09), about 86 million poor households are
covered under the SHG-Bank Linkage program with over 6.1 million saving-linked SHGs and
4.2 million credit-linked SHGs as on March 31, 2009.
11. The initial phase of SHG movement saw concentration of SHGs in the southern
parts of the country, but now the SHGs have spread more to the eastern and north eastern
regions where the extent of financial exclusion is greater. The Government of India has also
been using the SHGs for subsidy linked credit schemes for the poor. NABARD offers grant
assistance to NGOs that promote SHGs and link them to banks.
Mandated priority sector lending
12. Priority sectors broadly include agriculture and allied activities, micro and small
enterprises, education, housing and micro-credit. All domestic commercial banks are
required to allocate 40 per cent of their lending to the priority sectors. For foreign banks, the
requirement is 32 per cent and export credit is also included in their case. Credit extended by
banks to SHGs, micro finance institutions, to NBFCs for on-lending to priority sector, and to
regional rural banks for agriculture and allied activities have been included in the definition of
priority sector. Investments made by banks in securitised assets, representing loans to
various categories of priority sector which are originated by banks and financial institutions,
are also included in priority sector. A bank can also purchase priority sector lending from
another bank though participatory notes. Any shortfall in priority sector lending is required to
be deposited in special funds maintained by NABARD/SIBDI/NHB, which are used for
funding rural infrastructure/micro-enterprises/housing sectors. As on March 31, 2009, the
coverage under priority sector was to the tune of 51 million loan accounts. While it could be
argued that mandated credit distorts allocative efficiency of the banking system, I would like
to emphasise that no subvention is involved as interest rates are deregulated and all the
usual prudential norms for income recognition, asset classification and provisioning, as also
standard risk weights are applicable, which ensures that such loans do not add undue risk to
the bank's balance sheet.
Linking branch licensing approvals to penetration in under-banked areas
13. Under the current laws in India, every bank requires a license from RBI for opening
a branch. This legal requirement has been used as a regulatory tool for furthering financial
inclusion. Statutory approvals for branch licenses in more lucrative centres are linked to the
number of branches opened in under-banked districts and States, as also other factors such
as fulfilling priority sector obligations, offering no frills accounts and other parameters to
gauge achievements in financial inclusion and in customer service.
Opening of no frills accounts by banks
14. Taking the view that access to a bank account can be considered a public good, in
2005, RBI directed all banks to offer at all branches the facility of "no frills" account to any
person desirous of opening such an account. These accounts have nil or low minimum
balances and charges, and have limited facilities. Since 2005, over 39 million no frills
accounts have been opened. However, there are certain barriers that inhibit the active
operation of such accounts like the time and cost involved in reaching the nearest branch
where the accounts have been opened. Hence, we have, as will be described below allowed
branchless banking to ensure that these accounts are more accessible to their holders.
KYC regulations for small value clients and transactions
15. One significant area, where we found that regulation could be a challenge in
achieving greater financial inclusion is in regard to Know Your Customer (KYC) norms. In a
country where most of the low income and poor people do not have any document of identity
or proof of address it is very difficult to have KYC norms that insist on such documents. At
the same time, to ensure integrity of financial transactions, it is necessary that each customer
is properly identified before accounts are opened. In rural areas, this is addressed by asking
for identification by local officials and requiring a photograph of the account holder. Drives for
financial inclusion locally have been achieved through active involvement of government in
the identification process. In big towns and cities where there are a large number of migrants
who do not have any documents, fulfilling KYC norms and opening a bank account continue
to be a challenge. As a proportional regulatory dispensation having regard to the degree of
risk, RBI has simpler KYC norms for small value accounts where the balances in the account
do not exceed about $1000 and where the annual credits in the account do not exceed about
$4000. There are similar dispensations for walk-in clients for small remittances and
payments not exceeding US$1,000.
16. Recently, the Government of India constituted the Unique Identification Authority of
India (UIDAI) to issue a Unique Identification Number (UID) with biometric recognition to
every resident of the country. It is expected that by latter part of this year, the UIDAI will
begin issuing UIDs and roll out 600 million UIDs in a phased manner by 2014. UID enrolment
would be done with the help of State Government machinery and other Registrars. Banks
could benefit by synchronizing opening of bank accounts for those who will be enrolled
through this exercise. Government is also looking into the possibility of converting food and
fertilizer subsidies into cash payments which will flow through bank accounts. This project is
a unique opportunity to leverage UID, bank accounts and mobile telephony services. Using
UID for fulfilling KYC for small value accounts will facilitate financial inclusion. In a country
with deep penetration of mobile phones, this is expected to give a boost to the financial
inclusion while ensuring the integrity of financial transactions.
Branchless banking
17. With 600,000 villages in the country, we realised that it was impossible to provide
access to a bank account for every household through branch banking. At the same time,
electronic banking for such a populace where cash forms the dominant payment mechanism,
is unlikely to become a reality for quite some time. Keeping in view these ground realities,
RBI issued the business correspondent guidelines in 2006, which paved the way for
branchless banking through agents. The guidelines allowed, for the first time, commercial
banks to offer simple savings loan and remittance products through agents, who were
allowed to undertake banking transactions, including "cash in cash out" transactions at
locations close to the customer. Banks were advised as part of risk management to adopt
ICT solutions including biometric identification of the customer. The agents are required to
deposit bank's cash balances beyond certain limits with the bank's branches by end of day or
the next day. Initially, the regulations restricted the entities that could act as business
correspondents to "not for profit" entities such as NGOs/ cooperatives / post offices etc. This
was because we were concerned about the risk of reckless pushing of products by agents
whose sole incentive was earning commission; it was also felt that local community based
organisations and NGOs had the trust and confidence of the local population. Over the last
few years, the list of persons who can be appointed as business correspondents has been
relaxed to include individuals such as retired government officials , school teachers, defence
personnel as also "for profit" local "mom and pop" shops, petrol pump/public call office
operators etc entities that usually deal in cash in the villages. Another regulatory requirement
was that the business correspondents appointed for direct contact with the customers should
be within 30 km from a designated base branch of the bank to ensure proper oversight of
such agents and minimise agency risk. The distance criteria can be increased in consultation
with the district consultative committee, a forum for bankers and government officials that
meets each quarter. Initially there was a restriction on the bank in recovering any charge
from the customer for such doorstep service as it was expected that the savings in cost of
setting up a branch would be sufficient incentive. Subsequently, following a comprehensive
review of the business correspondent guidelines, we have relaxed this condition and banks
are now allowed to recover reasonable charges from the customer for providing the service.
Branchless banking illustrates an area where there have been progressive relaxations of the
regulations for furthering penetration while ensuring consumer protection.
Deregulation of interest rates for small loans
18. Currently, interest rates for loans up to Rs.200000 (about $4200) in the priority
sector are capped at the prime lending rates of banks. RBI has taken a decision to free the
interest rates, which will come into effect from July 1, 2010. Thus, these interest rates would
soon stand deregulated as long as banks ensure that the rates charged by them are
reasonable and transparent. This change in policy was based on the view that financial
inclusion can be viable and sustainable only if pricing is freed to cover costs even though
some cross subsidisation is possible.
Approach towards non-banking entities involved in financial inclusion
19. Non-Banking entities can be either non-banking non-financial entities or
nonbanking financial entities. In case of non-banking financial entities, we have had to deal with
two issues. The first is the question of allowing non-deposit taking financial companies
registered with the RBI, especially micro finance companies, to provide savings facilities and
deposit products for their clients. The argument put forth is that these entities are innovative
and nimble footed and have shown their ability to provide loan products to the poor.
Considering the difficulties is ensuring effective supervision of large number of small deposit
taking entities and the constraints in extending deposit insurance to such entities, the
regulatory approach in India has been to restrict deposit taking activity to banks while
promoting the branchless banking model for areas not served by bank branches. Hence
fresh approvals to NBFCs for accepting deposits are not considered, while capital, liquidity
and leverage requirements have been tightened for those already permitted to do so.
20. The second issue is that of allowing non banking financial companies especially
micro finance companies to act as business correspondents of banks for branchless banking.
The argument put forward is that this would enable their clients to access insured deposits,
national payments system and remittance services. There have also been demands that
large "for profit" companies having a wide network of outlets especially in rural areas could
be allowed to act as business correspondents of banks as there could be significant
synergies if such networks are leveraged upon. This issue is currently under examination
and in doing so the possible risks such as conflicts of interest, co-mingling of funds,
misrepresentation and other agency related risks would need to be weighed against possible
safeguards for consumer protection.
21. Non-bank non-financial entities have emerged as active players in financial inclusion
in that they have helped banks in offering customised payments and remittance services to
their customers based on innovative ICT solutions. Any role enhancement of non-banks to
become principals in provision of financial services implies that these non-bank entities
would have to be brought under financial regulation and this could inhibit their other activities.
Combining financial and non-financial business is also something the regulator may not be
comfortable with as there could be conflicts of interest. Our concerns have also been on the
access to and the use of float funds by such non-bank entities in the process of providing
such payments services. Many jurisdictions have dealt with this issue by asking the service
provider to maintain 100 per cent liquidity against float funds held by them and restricting the
value of transactions. Whether the escrowed funds/investments will be protected in the event
of bankruptcy of the service provider depends on the legal provisions and there could be
risks in such arrangements. In addition, there has to be clear regulatory authority over such
companies. Hence, our preference is to have a bank led system with non bank players as
partners and service providers, so that regulatory resources are focused on banks. Banks in
turn take responsibility for their partners and agents as part of their risk management
processes.
22. Subsequent to the notification of Payment and Settlement Systems Act, 2007, the
payment services have been opened up in India for non-bank service providers also. The
broad regulatory approach of RBI towards non-banks has been to permit these entities to
provide payment services which are fee-based without access to funds of the customers.
Indian regulations clearly spell out the role of telecom operators as service providers.
However, keeping in view the penetration of mobile telephony in the country, they have been
permitted to enable "m-wallet" facilities up to Rs.5000 (about $ 100) in the interest of small
retail payments.
Consumer protection issues
23. Amongst the various objectives of regulation, consumer protection should take
priority in the context of financial inclusion. In 2005, RBI took the initiative of setting up of the
Banking Codes and Standards Board of India (BCSBI) in order to ensure that comprehensive
code of conduct for fair treatment of customers was evolved and adhered to. The BSCBI is
registered as a separate society and functions as an independent and autonomous body.
The BCSBI has evolved two voluntary codes - one which is a code of commitment setting
out minimum standards of banking practices in dealing with individual customers. The other
is a code of commitment to micro and small enterprises. Individual complaints about non
adherence to the code fall within the jurisdiction of the Banking Ombudsmen who also
investigate individual complaints on non adherence to the various RBI guidelines on
customer service.
24. Other areas of consumer protection are related to excessive interest rates and harsh
recovery practices. In particular the high rates of interest charged by non banking micro
finance companies have attracted attention. Views have been expressed that with the
lending to MFIs included in the priority sector, there should be a cap on the interest rates
charged to the ultimate borrower. Efforts at financial inclusion can be sustained only if the
delivery models are viable and interest rate caps can be a deterrent. From a regulatory
perspective, we emphasise transparency, creating better awareness, customer education
and effective grievance redressal systems.
25. Financial literacy has to be an integral part of financial inclusion and consumer
protection. In fact, it should accompany and even precede the provision of financial services.
Several countries have a very clearly articulated vision and programs for financial literacy
with initiative from the central banks and regulators. We too have a comprehensive financial
literacy program. At the grass root level, financial literacy and grievance redressal is best
delivered by arranging regular meetings of communities with people's representatives, local
officials and bankers, NGOs and other stake holders. The Banking Ombudsman for the
region and the major controlling offices of banks attend such meetings and perhaps even
hold on-the-spot conciliation meetings for complaint redressal. Ultimately, responsible
borrowing facilitated by financial literacy and responsible lending by financial institutions are
essential for consumer protection and financial stability.
Summing-up
30. Financial inclusion primarily represents access to a bank account backed by deposit
insurance, access to affordable credit and the payments system. The Indian experience
demonstrates that financial inclusion can work within the framework of mainstream banking
within a sound regulatory framework. Regulations have been used to facilitate financial
inclusion without subventions or compromising on prudential and financial integrity norms.
Regulations have been proportional to the risks. Innovative solutions like SHG bank linkage,
branchless banking have been adopted after careful assessment of risks to the banks as
also to customers. The preference has been to restrict deposit taking to banks and non-bank
financial companies are encouraged to focus on innovative approaches to lending under a
lighter regulatory framework, with additional regulations for systemically important NBFCs
entities. Non-banking non-financial players are encouraged to be partners and agents of
banks rather than principal providers of financial services. Fair and transparent code of
conduct enforced through an effective grievance redressal system and facilitated by financial
literacy and education are the cornerstones for ensuring consumer protection which is an
overarching objective of financial regulation in the context of financial inclusion
Thank you.