The last-mile challenge in banking for the poor

It has always been thought that lack of access to formal bank accounts prevented poor people from saving more and once accounts were opened they would be able to more optimally manage their finances. But now that we have made some progress, albeit tiny (only 5.5% of 650,000 Indian villages have bank branches and half the adults in the country do not have access to bank accounts), with access through the campaign for total financial inclusion (TFI), have the desired outcomes been achieved for those people?

Surprisingly, it does appear that having a bank account does not automatically translate into its use, much less efficient management of personal finances. Livemint points to a study by Skoch Development Foundation which found that only 11% of 25.1 million no-frills accounts opened between April 2007 and May 2009 are operational mostly because of the high costs.

India Development Blog points to an IFMR study of the impact of TFI campaign in Gulbarga District of Karnataka (claimed to have achieved 100% financial inclusion), which found that 36% of sample households remained without access to formal and semi-formal savings mechanisms and more importantly, access to bank accounts did not translate into bank account usage. It was found that the accounts were used mostly to manage NREGS payments or SHG transactions. Critical to the lesser than expected account usage is the high transaction costs, especially by way of travel costs.

I am inclined to believe that even if access to formal banking systems, by way of opening a bank account, is increased, actual usage is likely to remain low unless bridge the last mile gap and take banking to the door-step of the people, especially in rural areas. The recent decision by the Reserve Bank of India to approve the deployment of mobile bank business correspondents, equipped with electronic terminals, to transact at the sub-branch level is certain to increase the quality of access. This will ensure that, unlike now, rural account holders are more likely to actively transact using their accounts.   

In this context, mobile phones have the potential to revolutionize banking and increase utilization dramatically. Mobile phones-based technologies offer the attraction of directly placing the bank account in the hands of the customer, thereby lowering transaction costs and increasing the likelihood of account usage. It may therefore be tempting to get carried away by this possibility, coupled with a campaign to increase financial literacy, and assume that it will ensure account usage.

However, dovetailing NREGS and other government cash transfers through TFI accounts, extensive use of business correspondents and mobile phone-bassed technologies, and financial literacy, while necessary are not sufficient conditions to ensure optimal account usage.In fact, unless complemented with other initiatives, mere increase in access to banking accounts, could be counter-productive. It could just as easily enable access to debt and other less than desirable financial products, whose extensive adoption could be detrimental to the interests of the poor people.

Behavioural science teaches us that even with access to their accounts and adequate financial literacy, human beings are cognitively constrained. This in turn means that despite firm commitment to save or spend on certain things, people tend to renege and fall short on achievement. People discount the value of later rewards by a factor that increases with the length of the delay. They are therefore tempted to spend on immediate needs as opposed to save for important long-term requirements. Further, drawing from theories of "mental accounting", it has also been found that people tend to save optimally when they they know what they are saving for.  

It is therefore necessary that the bank accounts are structured to address these cognitive biases. This assumes importance since we need to bear in mind that the ultimate objective is not to merely enable access to bank account, but to enable poor people with systems to more effectively manage their scarce finances. What can be done to ensure that poor people save more, optimize on their interest returns, manage their long-term needs like health care, children's education and pensions, make more effective purchase decisions, and so on? In simple terms, how do we ensure that people not only manage their finances effectively, but also overcome their cognitive urges which are often determental to their interests?

I have written about several examples of how innovative financial products can overcome such cognitive biases and increase the likelihood of optimal outcomes for poor people with management of their finances. In fact, bank savings accounts and financial products, with subtle commitment features, have the potential to dramatically increase not only usage but also effective usage of bank accounts. I have bloggged earlier about Save More Tomorrow, default pension savings, lottery savings products, products to increase fertilizer consumption, multi-tier accounts (also here), and budgeting family expenditures. See also this and this.

In this context, there is a big window of opportunity. Bill and Melinda Gates Foundation have just pledged $500 million to helping poor people learn to save money. They propose to fund research and project interventions in this area to emulate the examples like the hugely successful mobile banking for the poor — via cellphone in Kenya and Bangladesh and smart card in Mexico. Spurred on by the low domestic savings rate, this area has been the focus of considerable interest in the US too. It is appropriate that some part of this be leveraged into experimenting with financial products and structured accounts that help overcome cognitive biases.

It needs to be borne in mind that TFI and optimal utilization of bank accounts by the poor needs to go beyond mere door-step acceess to bank accounts.

Negative interest rate for microloans

This announcement by the Andhra Pradesh state government is certain to be another defining moment in the history of competitive populism in India, one that is certain to be emulated by atleast a few other states.

"The members of Self Help Groups in the Andhra Pradesh will get interest-free loans up to Rs 5 lakh from January 1... However, women would be eligible for interest waiver only if they ensure prompt repayment. As banks were now charging 14 per cent interest on loans to self help groups, the interest-free loans would cause a financial burden of Rs 1,400 crore on the State Government... To cater to the micro credit requirement, the government has set up a cooperative credit society under the name 'Stree Nidhi' with an initial corpus of Rs 1,054 crore."

Andhra Pradesh has an SHG bank linkage lending target of Rs 10000 Cr this year, nearly half the national target of Rs 22000 Cr. Of this Rs 10000 Cr, Rs 9000 Cr is in rural areas while the rest is for SHGs in urban areas. The state has 1.11 Cr women in SHGs.

Given the nearly 10% rate of inflation, the state government would actually be lending at minus 10% to these SHGs. It would form the most generous bank-lending program in scale anywhere (possibly anytime) in the world.

Visualizing Kiva flows

David Roodman has a superb graphical visualization of the cross-border flow patterns of over 4.3 million different types of microloans - education, health, food, agriculture, retailing etc - channeled through Kiva, the ostensibly person-to-person microlending site.

Intercontinental Ballistic Microfinance from Kiva on Vimeo.

The graphical illustration is stunning in its ability to convey the emergent dynamics of such activities. The flow patterns show how the numbers of lenders and borrowers build-up with time. Once a small trigger initiates the flow, (presumably) demonstration effects tap into latent demand among the massive pool of borrowers and generates confidence among lenders. It is also an excellent illustration of how social systems develop and the importance of initial patterns in consolidating the final outcomes.

The borrowers are concentrated in West Africa, Kenya, Latin America, Peru, Chile, Philippines, Indonesia, and parts of Eastern Europe whereas the lenders mainly come from US, West Europe, Australia and Japan.

On a more general note, I believe that a lot of complex public policy challenges can be more effectively communicated using vidualization graphics. For example, a time series trajectory of visuals of an area can highlight how specific infrastructure or other interventions there impacted the area's development in a cognitively striking manner. In fact, such visualization can beautifully capture the emergent dynamics of social and economic systems in response to specific triggers.

The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.

Are SHGs a public good?

Over the past year or so, the micro-finance movement has been the subject of intense scrutiny, faced with charges of fraud and exploitation. In Bangladesh, the Grameen bank and its iconic founder Mohammed Yunus have been accused by the Government of accounting fraud and diverting money. In Andhra Pradesh, micro finance institutions (MFIs) have been found indulging in practices that exploit the poor.

I have already blogged and written about these allegations and will not dwell on them here. Suffice to say that there are critical procedural/administrative problems and more importantly, serious corporate governance issues with many MFIs. In the absence of meaningful steps to address them, there are strong headwinds against any sustainable progress for the MFI model.

However, there are two interesting macro-perspectives from this debate, especially in Andhra Pradesh, that deserve greater discussion.

1. There is the argument that the spectacular success of MFIs in Andhra Pradesh overlooks the role of the government in creating a million-strong Self Help Groups (SHGs) that the MFIs could readily use (a la "ready cooked food"). There is palpable resentment at the fact that the MFIs, who merely walked in and piggy-backed on the fruits of the state government's efforts of more than a decade to develop SHGs, are claiming and getting a disproportionate share of the credit for the success of micro-finance activities in Andhra Pradesh.

In fact, the officials of the state government have even gone on record to argue that MFIs should confine themselves to non-SHG lending, "They cannot make profit by lending to the poor. Let them lend to the rich and make profit and leave welfare of the poor to the Government."

Without getting into the merits of how the credit for the success of micro-finance should be apportioned, it may be useful to examine what should be respective roles of the government and private sector in such areas.

Clearly, there are two distinct activities - formation and strengthening of SHGs and micro-lending to these SHGs. The strength of the former determines the success with the latter. In other words, SHGs form the fixed social infrastructure on which micro-finance rides.

I am inclined to see striking parallels between SHGs and classic public goods. It is now well-documented that apart from being channel to funnel credit to the poor, SHGs also play a critical role in women's empowerment and is a platform for enhancing the effectiveness of government interventions in many areas. Therefore, the net social benefits of SHGs exceed its net private benefits to the agency forming such groups. Private agencies like MFIs will naturally have less of an incentive to invest time and resources in forming SHGs.

In the circumstances, as is the case with public goods, it may be appropriate if governments focus on the formation of SHGs and invite the private sector to play a greater role with micro-lending. This does not mean an exclusive role for each in their respective areas, but a major role. So the way forward may be for governments to focus on forming SHGs and strengthening them, and for private sector to partnering with governments in increasing the volume of micro-lending. And all this assumes that the governance and other problems related to MFIs are largely resolved.

2. The second issue is related to the respective roles of the government and the private sector in combating poverty. More specifically, the success of the MFIs (most conspicuously, the success of SKS with its IPO) has generated a strong feeling that MFIs are making super-normal profits by exploiting the poor. This in turn raises the issue of what should be ethical standard for private agencies working in the area of development, the so called social enterprises.

Is it alright for a private social enterprise firm, playing by the rules of the game (assuming that the rules are themselves fair), to make profits even as it delivers on certain social objectives (as being delivered through the regular government initiatives)? In this case, is it acceptable if MFIs follow the rules, make micro-loans, and in the process also make handsome profits? Or should their profits be capped at some level? Or should the cost of lending be brought down and thereby reduce the excessive profit margins? Or should a share of their huge profits be ploughed back into helping the poor in some other effective manner?

In other words, is it acceptable for a private social enterprise, functioning with its capitalist efficiency and playing by the letter and spirit of the rules of the game, to work towards the objective of maximizing its profits?