H R Khan: Financial inclusion and financial stability: are they two sides
of the same coin?
Address by Shri H R Khan, Deputy Governor of the Reserve Bank of India, at BANCON
2011, organized by the Indian Bankers Association and Indian Overseas Bank, Chennai,
4 November 2011.
* * *
The speaker acknowledges the valuable contributions of Dr. Rabi N Mishra, Ms. Dimple Bhandia,
Ms. V. Vinitha and Mr. Surajit Bose in preparation of this presentation.
It is always a pleasure to be a part of such a confluence of bankers and researchers on
contemporary issues in banking and finance but to choose to speak on an area which needs
to be either "wholesomely new" or "extensively revised" at such a forum becomes a
challenge. I thank the organizers, the CMD of Indian Overseas Bank and the Chairman of
IBA for offering me this opportunity to share my own thoughts on a topical issue that has
engaged attention of policy makers in India and abroad in the recent times.
The Reserve Bank is intimately involved in efforts to ensure both financial inclusion and
financial stability in India. Being a part of this institution, I have had a very large intellectual
as also operational canvas to roam around. That in fact, encouraged me to avail of this
opportunity to discuss these two important dimensions of the economic issues which have
shaped the tone and tenor of financial sector policy space globally over the last decade or
so. The more one deals with them in juxtaposition, the more their mutual exclusiveness gets
demystified. Let me explain, how?
The importance of financial inclusion based on the principle of equity and on inclusive growth
with stability has engaged the renewed attention of policy makers internationally in recent
years. It is being increasingly recognized that despite tremendous growth in the banking
sector and significant improvements in all areas relating to financial viability, profitability and
competitiveness, the glass remains half-full. There remain concerns that banks have not
been able to include vast segments of the population, especially the underprivileged sections
of the society, into the fold of basic banking and financial services.
The recent global financial crisis has also brought the focus on financial stability to the centre
stage. The debate has been quite wide-ranging encompassing, inter alia, the definition of
financial stability and the implication of financial stability for growth and welfare. Many
lessons have been learnt. One, that financial stability can be jeopardized even if there is
price and macroeconomic stability. Two, that financial stability has to shift from being an
implicit variable to an explicit variable of economic policy and three, that a threat to financial
stability anywhere in the world is potentially a threat to financial stability everywhere. Fourth
and most importantly, we have learnt that while financial instability can hurt even the most
advanced economies, the damage it can cause in poor and developing economies can be
particularly severe. People with low levels of income have no headroom to bear downside
risks, and their livelihoods can be disrupted by financial instability. It is therefore even more
important that countries such as ours pay particular attention to preserving financial stability
even as we deepen and broaden our financial sector at home and integrate with the rest of
the world1.
The developments in the recent years have ensured that the pursuit of financial inclusion and
the pursuit of financial stability are no longer policy options but policy compulsions. The key
challenges emerging from this conclusion is how to achieve the goal of financial inclusion,
i.e., providing basic financial facilities to a wider segment of society while ensuring that the
stability of the financial system is not compromised. An important question which emerges is
whether increased and wider access to the formal financial services works in tandem with
policies aimed at enhancing financial stability or does it work at cross purposes and
jeopardize financial stability, i.e., are financial inclusion and financial stability two sides of the
same coin or are they two different disparate goals.
These are some of the issues I have picked up to enunciate. First, I will share my thoughts
on how financial inclusion and financial stability must co-exist and that it is difficult, in the
longer term, to envisage prevalence of one without the other. Next, I will discuss the various
ways in which financial stability and financial inclusion complement each other, going on to
discuss the ways that they may be in conflict and work at cross purposes. I will then touch
upon how a suite of enabling regulatory framework, effective policies for consumer protection
and greater financial awareness and literacy can work together to exploit the synergies
between financial inclusion and financial stability. Finally, I will briefly outline the manner in
which financial stability considerations have been woven into the Reserve Bank's initiatives
towards greater financial inclusion.
Financial inclusion and financial stability: mandatory co-existence
The first point I would like to make as I explore the relationship between financial stability and
financial inclusion is that the two must co-exist. Financial inclusion may be difficult without
the stability of the financial system while it is difficult to envisage continuing financial stability
when an increasing chunk of the socio-economic system remains financially excluded. Let
me elucidate.
Financial inclusion has been defined, by the Committee on Financial Inclusion, as the
process of ensuring access to financial services and timely and adequate credit where
needed by vulnerable groups such as weaker sections and low income groups at an
affordable cost2. It primarily represents access to a bank account backed by deposit
insurance, access to affordable credit and the payments system.
There has been significant, albeit, slow progress towards greater financial inclusion around
the world in recent years. According to estimates by an ADB Working Paper3, in Africa,
Kenya has pioneered an interesting process of financial inclusion through mobile phone
payment solutions. Latin American countries such as Peru and Bolivia have attempted to put
in place some very enabling regulatory environments for microfinance. In these two
countries, rapid growth over the past seven years has included six million clients in the
formal financial system. Brazilian policymakers achieved universal coverage of over 5,500
municipalities by enabling banks to use retail agents. This new low-cost delivery channel
triggered expansion of formal financial services to 12 million clients in only six years. Latin
America has also demonstrated the potential of conditional cash transfers into simplified
bank accounts as a way to connect beneficiaries to formal finance while simultaneously
lowering delivery costs to the government. Transfer challenges motivated the use of agents
in Brazil. In Mexico, beneficiaries increased savings and investment with more than 90 per
cent of households started to use banking services.
The benefits from financial inclusion are well understood and well documented. Financial
inclusion, more particularly when promoted in the wider context of economic inclusion, can
uplift financial conditions and improve the standards of lives of the poor and the
disadvantaged. Access to affordable financial services would lead to increasing economic
activities and employment opportunities for rural households with a possible multiplier effect
on the economy. It could enable a higher disposable income in the hands of rural households
leading to greater savings and a wider deposit base for banks and other financial institutions.
It will enable the Government to provide social development benefits and subsidies directly to
the beneficiary bank accounts, thereby drastically reducing leakages and pilferages in social
welfare schemes. Thus, financial inclusion could be an instrument to provide monetary fuel
for economic growth and is critical for achieving inclusive growth. Further, expanding the
reach of financial services to those individuals who do not currently have access would be an
objective that is fully consistent with the people-centric definition of inclusive growth which
attempts to bridge the various divides in an economy and society, between the rich and the
poor, between the rural and urban populace, and between one region and another.
An analysis of World Bank Development Indicators implies a strong link between financial
access (measured in terms of commercial bank branches per 100,000 adults and deposits
per 1000 adults) and economic development. Empirical evidence indicates a distinct rise in
income level of the countries with higher number of branches and deposits of commercial
banks. Higher number of bank branches per 100,000 adults and more number of deposit
accounts per 1000 adults are observed in high income countries than countries in the low
and middle income categories. Though the cause-effect relationship could be the subject of
detailed research, the fact that there is a progressive increase in income levels of the
countries as financial access increases is empirically evident.
Source: World Development Indicators 2010, World Bank
Just as it is difficult to envisage continuing financial stability without financial inclusion,
especially in the long term, it is difficult to envisage the success of policy efforts to expand
the reach of financial services unless banks and other financial services providers are sound,
the financial markets are functioning smoothly and financial market infrastructure is robust. A
recent World Bank report shows4 that nearly 60 percent of the economies experienced a
contraction in real per capita income in 2009 as a result of the deepening of the global
financial crisis. Worldwide volume of deposits and loans shrank, with a median decrease of
12 percent in the ratio of deposit value to Gross Domestic Product (GDP) and a median
decrease of 15 percent in the ratio of value of loans to GDP.
I have discussed how financial inclusion and financial stability need to co-exist if policy
measures pursuing either objective have to achieve any degree of success. Let me return
now to the key question I flagged at the outset - whether financial inclusion and financial
stability are two sides of the same coin and mutually reinforce each other or are they
disparate goals that would contradict each other and work at cross purposes. There are, in
fact, several ways in which financial inclusion can contribute to maintaining a sounder and
more stable financial system.
Financial inclusion and financial stability: working in tandem
First, financial inclusion can improve the efficiency of the process of intermediation between
savings and investments while facilitating change in the composition of the financial system
with regard to the transactions that take place, the clients that use the various services, the
new risks created, and possibly the institutions that operate in newly created or expanded
markets. As the balance sheet of the financial sector grows more diversified and
encompasses a broader spectrum of economic agents, its contribution to a more resilient
economy is commensurately higher.
Second, for financial institutions, especially banks, financial inclusion helps provide a more
stable retail base of deposits. As the recent global crisis also demonstrated, stable retail
sources of funding as against reliance on borrowed funds can greatly enhance the
soundness and resilience of financial institutions and can reduce volatility in earnings. Low
income savers and borrowers tend to maintain steady financial behaviour through the
business cycle both in terms of deposit keeping and borrowing. Thus, during periods of
systemic crises, deposits from low income clients typically act as a continued source of funds
even as other sources of credit dry up or become difficult to roll over. Small customers, thus,
provide big opportunities to garner stable deposits. In the absence of such deposits, financial
institutions may find it difficult to continue lending. This credit channel has the potential to
aggravate the impact of the crisis on the local economy than would otherwise be the case.
Third, financial inclusion facilitates greater participation by different segments of the economy
in the formal financial system. The presence of a large informal sector can impair the
transmission of monetary policy as a significant segment of financially excluded households
and small businesses make financial decisions independent of, and un-influenced by, the
monetary policy actions of the central bank. As the share of the formal financial sector
increases through greater financial inclusion, it yields an important positive externality by
making monetary policy transmission more effective.
Fourth, to the extent that financial inclusion helps people move from the cash economy to
bank accounts which can be monitored, it helps facilitate implementation of Anti-Money
Laundering and Combating the Financing of Terrorism (AML/CFT) guidelines and makes it
possible to deploy suspicious transactions' monitoring and reporting to a larger share of
financial transactions in the economy. Recent Financial Action Task Force (FATF) Guidance
on5 "Anti-Money Laundering and Terrorist Financing Measures and Financial Inclusion"
concluded that financial exclusion undermines the effectiveness of an AML/CFT regime and
recommended that a country's level of financial inclusion and initiatives to expand financial
inclusion should be considered, when the effectiveness of their AML/CFT regime is
assessed.
Fifth, financial inclusion can contribute to enhanced financial stability through contributing to
the improved health of the household sector, of small businesses and, to some extent, that of
the corporate sector. The health of the household sector is improved through improved
economic linkages, reducing reliance on the costly informal sector and through improved
ability to make and receive payments. The benefits of this cannot be overstated given that for
the household sector the implications of a lack of access to banking services can be severe.
Lack of access affects the ability of a household to receive government transfers, or to make
payments or to accumulate cash surpluses for planned expenses or emergencies.
Individuals who have no option but to carry cash are exposed to security risks. Such access
also reduces the cost of making payments. Social benefits include protection against loss
due to theft, improved mechanisms for social transfers and other remittances (including tax
and benefit remittances) and improved economic linkages for the rural and deprived
communities6.The lack of access to or availability of a vehicle for saving could also result in
households, especially low income households, resorting to expensive short-term debt.
There are many anecdotal instances of high interest rates leading to households being
caught in a debt trap in our own country while the impact on financial stability of increased
leverage of households was succinctly demonstrated by the recent crisis in the microfinance
sector.
Financial inclusion can improve the access to finance and the quality and cost of the service
that small businesses receive from banks. These factors are key to the profitability and
prosperity of these businesses and that of the economy. Research has revealed increased
formal savings can help reduce cost of credit and facilitate business expansion, for example,
through increased availability of low cost deposits. This has the collateral benefit of improving
resilience of small businesses, even large businesses.
Sixth, in most cases, efforts to include an increasingly larger section of the population within
the fold of formal banking and financial services have resulted in the deployment of
innovative solutions and outsourcing arrangements. Such financial innovations have the
potential of reducing costs and thereby contributing to increasing the overall efficiency of the
economy and the financial stability. They may also, through faster information dissemination
and more efficient functioning of the financial markets, contribute to improving the efficiency
of transmission of monetary policy. Of course, financial innovations and outsourcing
arrangements come with their own set of risks which could pose challenges for the overall
policy framework for the pursuit of financial stability. But I will discuss this a little later.
Finally, financial inclusion, through careful policy orientation, may help facilitate reduction in
income inequalities and, by bridging the gap between the prosperous and the poor, can
foster social and political stability.
Financial inclusion and financial stability: working at cross purposes
This is not to say that there are no risks to financial stability emanating from greater financial
inclusion. One only has to recall the savings and loan crisis in the US in 1980s to appreciate
that even financial institutions geared to cater to the retail investors and, thereby, to foster
financial inclusion, could be a source of financial instability.
The recent crisis in US subprime markets is another case in point. Policy makers have often
endorsed marketing to subprime borrowers as a means of financial inclusion7. With hindsight,
it seems clear that such over-extension of credit has the potential to affect the quality of the
credit portfolio of banks and financial institutions and could have sown the seeds of financial
fragility, and ultimately of financial instability. The position may be further aggravated by
regulatory or governmental forbearance which has the potential to vitiate the credit culture
amongst the target group. As elucidated by Prof. Raghuram Rajan8, "easy credit" as a
response to bridge the gap between the haves and the have-nevers could prove to be a
costly way of redistribution and create a fault line along the financial sector where enormous
stresses could build up and lead to an instability in the system akin to the subprime crisis of
recent times.
Our own experience with local entities, such as, cooperative banks, deposit taking
nonbanking financial companies and Regional Rural Banks - which are largely geared to meet
the needs of the poor and the un-banked - has highlighted the risks of poor governance,
connected lending, geographic concentration leading to vulnerability to natural calamities and
downturns. The recent experience of the microfinance industry is another example of an
initiative to foster financial inclusion resulting in financial stress to the very institutions which
are promoting inclusion. Hence, the risks for financial institutions catering to the less
developed and low-income markets need to be well understood.
First, these markets typically involve a large number of low ticket clients/transactions with
commensurate burden on operating costs. Second, these segments are typically associated
with informational inefficiencies with most borrowers unable to produce any collateral or to
provide an adequate track record of repayments. Third, financial institutions venturing into
these segments for the first time often need to incur substantial costs as they adjust their
business practices and processes to the fresh rules of the game. Fourth, financial services
can be used to launder illegally obtained funds as well as fund terrorist activities. This could
be accentuated if for expansion of finance access too much of regulatory forbearance by way
of relaxed KYC norms is given even for large volume/high frequency transactions. While, as
discussed above, greater financial inclusion can facilitate monitoring of a larger share of
suspicious transactions, the emergence of payment services, in particular person to person
remittance facilities, to cater to the needs of an increasing large base of retail clients may
also provide opportunities for illegal activities. Conversely, there are challenges posed by
AML-CFT requirements to the goal of achieving financial inclusion and, hence, the FATF
Guidance states there is a need to "take account of the nexus between financial integrity and
financial inclusion and the cross-reinforcement between these two objectives".
Fifth, outsourcing of activities by banks, including for financial inclusion, also poses
reputational, financial and fidelity risks which may impact the health of the institution and of
the financial system9. In particular, the reputation risks associated with outsourcing may
impact the activities of the entire bank and not just the outsourced activities in case of any
mishap or misdemeanour by the outsourced agents. There are also systemic risks
associated with the entire banking industry relying on a single or a few vendors, as is
frequently the case, especially in the early stages of innovations/outsourcing. These risks
need to be carefully managed by banks, in particular, through a system of checks and
balances which could, inter alia, involve well defined contractual arrangements, standards for
due diligence, exposure monitoring, cash and other limits, rating of the agents/Business
Correspondents (BCs), periodic audit/inspection, etc. and the use of information,
communication and technology (ICT), for managing operational and financial risks. Further,
the design of appropriate compensation structures, including performance based features,
can ensure a reasonable fee to the agents while ensuring adequate incentives for preventing
misuse of the system by the agents.
Sixth, risks would also arise out of the business model of specialised non-bank institutions
{e.g. Micro Finance Institutions (MFIs)} which cater exclusively to the needs of the low
income group. These institutions face concentration and funding risks which can contribute to
overall systemic risks as has been amply demonstrated by the recent experiences in Andhra
Pradesh. The greater involvement of commercial banks in the provision of services to the low
income group and with institutions catering to the low income segment can go a long way
towards mitigating the risks.
Finally, as I discussed earlier, the pursuit of financial inclusion has often been attempted
through low cost delivery channels, innovative products and outsourcing agencies. These
developments come with their own set of risks which could jeopardize financial stability. For
example, during times of stress, financial innovation can further complicate the transmission
of monetary policy. In any case, during periods of financial instability, it may be difficult to
predict the consequences of financial innovations thereby adding an additional element of
uncertainty to an already uncertain economic environment.
Facilitating financial inclusion with financial stability: financial regulations and literacy
& consumer protection
Let me quickly sum up the discussions so far. It is clear that there are some potential costs of
financial inclusion. There are also some important benefits which play out over cycles of
booms and busts and through periods of financial crises. The end result is a deeper, more
diversified and resilient financial system as well as healthier corporate and household sectors
which can enhance financial stability. There are risks to the financial institutions from
financial inclusion. There is, however, not enough evidence that these risks are hugely
systemic in nature. On the contrary, savers and borrowers in the lower segment have been
evidenced to maintain more consistent financial behaviour during financial crises as
compared to customers in other segments. To this extent, they add to the resilience of
financial institutions. In any case, the risks prevalent at the institutional level are manageable
with known regulatory & prudential tools, greater financial awareness and literacy and with
more effective customer protection practices.
As highlighted at the very outset, achieving greater financial inclusion and maintaining
financial stability are now complementary policy compulsions. The challenge is to ensure
both while exploiting the synergies between the two policy objectives. The answer arguably
lies in a facilitative regulatory and supervisory structure which ensures that the formal
financial system delivers affordable financial services to the excluded population with greater
efficiency without compromising on the acceptable levels of safety and soundness. In this
connection, an important role can be played by credit information bureaus that provide a
database to capture all outstanding loans for individual borrowers and in prevention of
multiple-lending and over borrowing10. Also important is a regulatory environment which
facilitates the promotion of new lines of businesses with idiosyncratic risk profiles whose
contribution to systemic risks is relatively low.
An effective consumer protection policy framework is also a critical component of any
regulatory environment which aims at meeting the goal of financial inclusion while promoting
the soundness and resilience of institutions and of the financial system. For the entire
framework to be effective, greater financial literacy and awareness would remain very critical.
There are a range of cross country experiences which testify to the efforts underway for the
achievement of a balance between financial inclusion and financial stability through a
facilitating regulatory framework, especially relative to consumer protection and reputational
risk mitigation. Let me briefly recount some such experiences which have supported an
accessible and stable financial sector environment in their respective jurisdictions:
a. Brazil, new regulations have been attempted to achieve universal access by
enabling partnerships between banks and third-party agents. Brazil was the early
leader in agent banking through the large-scale introduction of "banking
correspondents" to distribute welfare grants to unbanked Brazilians. The oversight is
focused on the financial institution with the central bank getting access to all data on
the agents while attempting to also give the financial institution enough freedom to
articulate the relationship with the agents on their own terms.
b. Kenya and the Philippines, where central banks have had a key role in supporting
mobile phone payment schemes and allowed regulatory space to mobile phone
operators. In Kenya, the e-money transfer service M-PESA offered by mobile
network operator Safaricom has achieved impressive progress thus far.
c. Philippines launched the first successful mobile payment service in a developing
country in 2004. Once market innovation and learning satisfied the needs of
regulators and mobile operators, regulation was created and implemented to provide
legal certainty and create a level playing field to allow new players.
d. Bolivia and Uganda, which also demonstrated that micro-deposit-taking can flourish
in the regulated financial system with timely and appropriate policies. Regulators
have incorporated non-profit innovators into the formal system by creating legal
paths toward a license. New laws, specially designed for previously unregulated
NGOs, were passed, whereby they will keep their non-profit status and be allowed
to collect deposits and offer extra financial services.
e. Indonesia, which has proved how public-owned financial institutions may become
the driving force behind economic development in rural areas. The government
owned development bank, Bank Rakyat Indonesia (BRI), which specializes in
microfinance is the biggest provider of rural financial services within Indonesia. Even
when the Indonesian banking system collapsed during the Asian financial crisis,
BRI's micro-banking division remained relatively profitable 11.
It is, however, important to note all these experiences need to be evaluated in the country
specific context and their replication in other jurisdiction has to be carefully thought through.
The lesson, however, is that prudential regulation has an important role to play in ensuring
the initiatives taken to provide basic financial services do not themselves become a source of
risk or fraud. Prudential regulations which ensure the soundness of financial institutions
providing basic financial services to the excluded, on the one hand, and which put in place
robust consumer protection guidelines, on the other, bolster public confidence in the various
initiatives taken to ensure greater financial inclusion.
If regulations are to foster financial inclusion, they need to be commensurate with risks. A
recent BIS paper12 highlights the need for regulation of financial innovations for financial
stability to be calibrated to the nature and risks of each different service/innovation. In
calibrating the regulatory framework for basic financial services according to their
contribution to systemic risks for the entire financial system it will be necessary to ensure that
financial regulation itself does not become a cause for exclusion.
The Indian experience
Let me now briefly describe the Indian experience with financial stability and financial
inclusion.
Financial stability is not a mandate of the Reserve Bank of India as per its statute. Financial
stability considerations have, however, always been taken note of by the Reserve Bank in its
policy making process. This is particularly so in the period since the balance of payments
crisis in the early 1990s. Since 2004, financial stability has been formally added as a policy
objective of the Reserve Bank of India along with price stability and inclusive growth. More
recently, financial stability is being pursued explicitly by the Reserve Bank with the setting up
of a Financial Stability Unit with the remit to conduct continuous macroprudential surveillance
of the economy.
Financial inclusion has also been a major policy objective in the Indian context since long
though the term financial inclusion has come to the forefront only of late. In fact, the Reserve
Bank is perhaps the only central bank in the world which attempts to reach the remotest
locations of the country in a bid to create awareness and promote inclusion. The objective of
achieving greater financial inclusion in India has been pursued in a regulated space. The
framework for financial inclusion has been bank led to a large extent and banks are closely
regulated and supervised entities in the Indian context. Non-Banking Financial Companies
(NBFCs) engaged in activities which facilitate financial inclusion are also largely regulated
while a regulatory framework for the Micro Finance Institutions (MFIs) is also under
contemplation13. Importantly, the broad compulsions of the health and resilience of financial
institutions and that of financial stability have not been lost sight of even as financial inclusion
has been pursued with vigour. It is pertinent to note at this point that the remit of the recently
established Financial Stability and Development Council (FSDC) which is the apex level
inter-institutional body for financial stability in the country also includes financial inclusion.
The foundation for promoting greater financial access in the country can be traced to the
findings of the all-India Rural Credit Survey in the early 1950s. The findings of the Survey
indicated that, out of the total borrowings of farmers in 1951-52 estimated at Rs. 7.5 billion,
commercial banks provided less than one per cent while moneylenders provided 70 per cent.
The distribution of bank branches was also highly skewed in favour of urban and
metropolitan/port centres in 1969. Even in terms of distribution of bank credit, the share of
private corporate business exhibited an overwhelming increase, from 44 per cent during
1957-61 to over 60 per cent for the quinquennium ending 196914.
These disturbing features brought out by the survey culminated in the process of
nationalization of major public sector banks with a view to leveraging the banking system as
a tool for promoting a slew of social objectives of which inclusion was one. The initiatives in
this direction included the requirement that banks could open a branch in a location with one
or more branches only if they had opened four in a location with no or a few branches. The
branch licensing policy of the Reserve Bank of India has undergone a sea change since then
in terms of liberalisation but the cornerstone of the policy, till date, remains one of
encouraging banks to open an increasing number of branches in the less banked regions of
the country by linking of the regulatory framework for opening bra