Financial Regulation and Financial Inclusion Working Together or at Cross-Purposes

Usha Thorat
Deputy Governor, Reserve Bank of India

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 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, the 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.

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.

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.

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? The issues that merit attention are:

• 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? and
• Financial regulation and financial inclusion – is there a trade off?

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, there is no doubt that financial regulation and financial inclusion work together – the former is a must for the latter.

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. Such growth is not possible without capital. Investors and lenders are comfortable with providing more funds only if such entities are regulated.

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

The key message here is that the regulatory approach has not compromised with prudential norms for deposit taking entities. Only sound and strong institutions can deliver financial inclusion. Within the overall traditional prudential framework, what the Reserve Bank of India has tried to do is to have a system of incentives and disincentives that further the financial inclusion objective and while doing so balance the degree of the risk with the ability to achieve greater penetration.

Looking at the success of credit unions and community banks worldwide in providing financial services to local communities, it can be argued that smaller regional banks can 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.

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.

Taking the view that access to a bank account can be considered a public good, in 2005, the 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, the RBI allowed branchless banking to ensure that these accounts are more accessible to their holders.

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, the 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 $1,000.

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. 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 will be done with the help of State Government machinery and other Registrars. Banks can benefit by synchronizing opening of bank accounts for those who will be enrolled through this exercise. 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.

ApproachTowards Non-Banking Entities

Non-banking entities can be either nonbanking non-financial entities or nonbanking financial entities. In case of nonbanking 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.

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. 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.

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.

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 nonbank 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.

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.

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. 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.