Financial Deepening Catalyst Growth with Finance

With Finance Minister Pranab Mukherjee spearheading the policy initiative, there is swell of opinion that a high level of financial deepening is a necessary condition for accelerating and sustaining growth in the economy. To bring about inclusive growth, this translates into urgent action on the financial inclusion front, Team Inclusion reports

01 July, 2010 Finance, Research Reports
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“There is an urgent need for including people from all strata in the mainstream banking system and for putting our country firmly on the path of overall growth and development,” said Finance Minister Pranab Mukherjee at a meeting between chief ministers and bankers in June. The meeting, the second in a series, only confirms that increasingly the UPA government is convinced and committed to the role of financial inclusion in achieving its overall goal of inclusive growth. Mukherjee also advised banks to convert savings from semi-urban and rural markets into financial assets through effective financial inclusion.

Undoubtedly, financial inclusion is one of the key elements that will give a thrust to financial deepening and thus economic growth, given that India has over 50 per cent of the population which has no access to banking. Financial deepening encompasses the increase in the stock of financial assets. From this perspective, financial deepening implies the ability of financial institutions in general, to effectively mobilise financial resources for development. This view accepts the fact that a financial system’s contribution to the economy depends on the quality and quantity of its services and the efficiency with which it performs them

“We cannot have depth in the market if the number of participants in the market place is not increased and that is why financial inclusion is related to financial deepening. We have to create an appropriate platform using technology and devise innovative products. The entire financial inclusion exercise is in mission mode so that we can achieve our ambitious goals,” says K C Chakrabarty, Deputy Governor, Reserve Bank of India.

The Bank for International Settlements in its 2009 annual report stated that it is useful to think of the financial system as the economy’s plumbing. And like the plumbing in a house, the modern economic system depends on a reliable flow of financing through intermediaries. Modern life requires the smooth operation of banks, insurance companies, securities firms, mutual funds, finance companies, pension funds and governments. These institutions channel resources from those who save to those who invest, and they are supposed to transfer risk from those who can’t afford it to those who are willing and able to bear it.

Mobilising Savings for Investment

“There are meso-economic determinants also, especially in terms of the infrastructure sector, in areas like energy, water, and other major intermediaries. And, to sustain a positive growth momentum and get the right kind of growth, we urgently need to undertake reforms in these areas.”
Vijay Kelkar

A high level of financial deepening is a necessary condition for accelerating growth in an economy. This is because of the central role of the financial system in mobilising savings and allocating the same for the development process. The financial system serves as a catalyst to economic development through various institutional structures. The system vigorously seek out and attract the reservoir of savings and idle funds and allocate same to entrepreneurs, businesses, households and government for investments projects and other purposes with a view of returns. This forms the basis for economic development. The financial system play a key role in the mobilisation and allocation of savings for productive, use provide structures for monetary management, the basis for managing liquidity in the system. It also assists in the reduction of risks faced by firms and businesses in their productive processes, improvement of portfolio diversification and the insulation of the economy from the vicissitudes of international economic changes. Additionally, the system provides linkages for the different sectors of the economy and encourages a high level of specialisation expertise and economies of scale.

Recently, C Rangarajan, Chairman, Prime Minister’s Economic Advisory Council, said “the role of an integrated financial infrastructure in stimulating and sustaining economic growth is well recognised. It is now widely accepted that financial intermediation is essential for both extensive and intensive growth.”

“Efficient intermediation of funds from savers to investors enables the productive application of available resources. The greater the efficiency of the financial system in such resource generation and allocation, the higher is its likely contribution to economic growth. Such efficiency creates a virtuous cycle of higher real rates of return and increase in savings resulting in higher resource generation. Thus development of the financial system is essential to sustaining higher economic growth,” he pointed out.

Santanu Paul, Chief Executive Officer & Managing Director, TalentSprint, said financial deepeners comprise technology, psychology and human capital and these should allow a financial institution to do one of two things, which will either help you reach new customers more easily and more readily or expand relationship with the existing customers more profitably.

It was also felt that as a developing country, the country that really needs to get its savings to its investors and not expose the country to external vulnerabilities. Ways of liberalising the financial sector needed to be explored rather than put in more regulation and make the cost of financial intermediation much higher.

According to Joseph Massey, Managing Director & Chief Executive Officer, MCX Stock Exchange, “financial deepening is the first thing for inclusive growth and if financial deepening is not happening to an extent we think it should, somewhere there is an issue dealing with competition.”

Chakrabarty also notes that financial sector development and deepening drives economic growth by mobilising savings and investing in the growth of the productive sectors. The institutional infrastructure of the financial system contributes to reducing information, contracting and transaction costs, which in turn accelerates economic growth and promotes pro-poor growth.

Opportunities for Banking Sector

New technologies such as mobile banking combined with innovative business models can deliver a stepchange in effectively servicing lowincome- customers. Institutional, policy and regulatory frameworks needed to evolve to provide a robust platform for further innovation. The challenge for regulators will be to reshape legislation in ways that protect the customer, but do not hamper the development of innovation.

Financial inclusion plans must be integrated with the normal business plans of the banks. Chakrabarty adds, “we believe that banking to the poor is a viable business opportunity but costs and benefit exercise needs to be attempted by the banks to make financial inclusion congruent with their business models.” While seemingly committed to financial inclusion, banks need to reorient their perspective and view it as a huge business opportunity and perfect their delivery models.

“One just had to travel to the countryside to see the difference between a policy, which is a very well intentioned and documented framework, and its implementation. There exist huge gaps and at times people don’t actually see those gaps and the difficulties at the ground level in terms of implementation.
Vinita Bali

In spite of taking several initiatives in the past, the Indian banking industry has been able to penetrate only a half of the population for easy and cheap access to institutional credit facilities. In this context, the RBI has taken a number of steps in the recent past which will further the process of financial inclusion. Its efforts in adapting to the changing needs of the economy and enabling greater access to financial services to the unreached and under-reached segments of our population have been particularly praiseworthy. There are in fact few, if any, instances of an economy transiting successfully from an agrarian system to a post-industrial modern society without broad-based financial inclusion.

Despite the aggressive growth in most financial segments over the past decade, there is still the underpenetration of most financial products/ services. Even though Indian banking credit has enjoyed a significant growth during the period 2003-08, credit penetration remains well below regional benchmarks, which is suggestive of healthy growth potential in the medium term. Indian financial sector offers structural growth opportunities and an expanding target market. In India, it is the household sector which generates largest savings in relation to the private corporate and public sectors, in that order. A significant proportion of household financial savings is routed through the banking system. As of 2008-09, while the household deposits accounted for around 54 per cent of the gross financial assets, bank credit accounted for around 94 per cent of household financial liabilities.

Although significant financial deepening has been taking place in Indian economy over the years as seen from the deposit-GDP ratio, bank assets- GDP ratio and credit-GDP ratio, the low levels of penetration in India can provide a medium term structural growth driver for banks. A noteworthy feature discernible in the Indian context is that the rise in indicators of financial deepening takes place along with a noticeable rise in the domestic savings rate. This has to be seen in the backdrop of financial sector reforms, rise in total farm productivity and investment boom which has led to acceleration in the growth performance.

Being convinced that technology is the key for improving in productivity, the Reserve Bank took several initiatives to popularise usage of technology by banks in India. Periodically, almost once in five years since the early 1980s, the Reserve Bank appointed Committees and Working Groups to deliberate on and recommend the appropriate use of technology by banks given the circumstances and the need.

Role of Financial Education

Delivering the inaugural address at an international workshop on ‘Delivering financial literacy: challenges, strategies and instruments,’ organised jointly by the Reserve Bank of India and the Organisation for Economic Cooperation and Development (OECD) in March this year, Finance Minister Pranab Mukherjee said that financial literacy is a prerequisite for effective financial inclusion, which will ensure that financial services “reach the unreached and under-reached sections of the society”.

Mukherjee said efforts to improve literacy should take into account India’s “divergent and multi-lingual framework”. The wide divergence in literacy levels across States and within States, the marked differences between rural and urban areas are also important issues in India, he said. The “perceptible variation in the penetration of banking across regions,” was also an important factor, he added. The focus of any discussion on financial education is primarily on the individual, who usually has limited resources and skills to appreciate the complexities of financial dealings with financial intermediaries on matters relating to personal finance on a day-to-day basis. Further, the process of educating may invariably involve addressing deep entrenched behavioural and psychological factors that could be major barriers.

In a country like India, with diverse social and economic profiles, financial education is particularly relevant for people who are resource poor and who operate at the margin and are vulnerable to persistent downward financial pressures. With no established banking relationship, the unbanked poor are pushed towards expensive alternatives. The challenges of household cash management under difficult circumstances with few resources to fall back on could be accentuated by the lack of skills or knowledge to make well informed financial decisions. Financial education can help them prepare ahead of time for life cycle needs and deal with unexpected emergencies without assuming unnecessary debt.

Establishing the Linkage

In the literature of development economics, it is generally held that the depth of financial development promotes economic growth in two ways. First, it facilitates resource mobilization, reduces the transaction costs of financing investments, and therefore, induces more investments (e.g., Merton and Bodie 1995). Second, it helps improve the allocative efficiency of financial resources, and thus lift the returns to financial resources, which raises productivity (e.g., King and Levine 1993; Beck et al. 2000).

Various studies have shown that there is a strong and positive relationship between the financial sector and economic development. According to Porter (1966) the level of financial institution development is the best indicator of general economic development. Furthermore, Goldsmith (1969) contends that financial institution development is of prime importance for real development because the financial superstructure in the form of both primary and secondary securities accelerates economic growth and improves economic performance to the extent that it facilitates the migration of funds to the best user.

Popiel (1990) conducted one of the most elaborate studies on financial deepening. According to him, financial markets are deep from a qualitative standpoint when:

  1. They offer savers and investors a broad range of financial instruments which differ in terms of liquidity, yields, maturities and degree of risk including debt instruments, equity instruments and in between quasi-equity instruments.
  2. They encompass a diversity of sub-markets, trading in different financial instruments.
  3. Mature, domestic financial markets are integrated into the international financial markets.
  4. Are linked together through financial instruments.
  5. Finally, the markets are linked together through various financial institutions which function as market makers and financial intermediaries.

Rajan and Zingales (1998) argue that financial development facilitates economic growth by reducing the costs of external finance to firms; their empirical evidence from a crosscountry study supports this rationale. Guiso, Sapienza and Zingales (2004) examine the effects of differences in local financial development that can explain the spread of entrepreneurship and economic growth

Need for Innovation

Finance Minister Pranab Mukherjee addressing at the SHG-Credit Linkage Programme, at Pondicherry on 3rd July 2010

The statistics on financial exclusion in India provide a dismal picture. Out of the 600,000 habitations in the country, only about 30,000, or just 5 per cent, have a commercial bank branch. Just about 40 per cent of the population across the country has bank accounts, and this ratio is much lower in the north-east of the country. The proportion of people having any kind of life insurance cover is as low as 10 per cent, and the proportion having non-life insurance is an abysmally low 0.6 per cent. People having debit cards comprise only 13 per cent and those having credit cards a marginal 2 per cent.

These statistics, staggering as they are, do not convey the true extent of financial exclusion. Even where bank accounts are claimed to have been opened, verification has shown that a significant portion of these accounts are dormant. Very few conduct any banking transactions and even fewer receive any credit. Millions of people across the country are thereby denied the opportunity to harness their earning capacity and entrepreneurial talent, and are condemned to marginalisation and poverty.

Who are the Financially Excluded

  • Poor
  • Socially under under-privileged
  • Disabled
  • Old as well as children
  • Women
  • Uneducated
  • Ethnic minorities
  • Unemployed
  • Low income self-employed
  • Agricultural and industrial labour
  • Those engaged in unorganised sector

Most Needed Services for Financially Excluded

  • Access to small loans or overdrafts
  • Check in accounts
  • Small savings products
  • Remittances & Payment services
  • Health insurance
  • Life insurance
  • Insurance against the failure of activity
  • Financial advisory services
  • Credit card
  • Entrepreneurship credit
“The role of an integrated financial infrastructure in stimulating and sustaining economic growth is well recognised. It is now widely accepted that financial intermediation is essential for both extensive and intensive growth. Efficient intermediation of funds from savers to investors enables the productive application of available resources.”
C Rangarajan

A sector that is begging for greater innovation is insurance. Within the sector, the top management is clearly seized of the matter. “The penetration rate of general insurance has been stagnant for the last decade. We need to reach out to large sections of the populace who are still not covered. There is huge potential. To tap this potential, we need to focus on affordability, reach in terms of low-cost models and diversity in the product portfolio,” says G Srinivasan, Managing Director, United India Insurance.

Product innovation may hold the key. As M Ramadoss, Managing Director, New India Assurance, points out, “To further financial deepening, we need to sell small-ticket policies at low cost. For this, IRDA should consider relaxing the need for paper policies where the premium is below Rs 1,000. There should also be some liberalisation in agent appointments as the probability of misselling is much lower in general insurance. Kirana shops should be allowed to sell small-ticket policies like cover for motorcycles.”

Remittances too have been identified as a potential catalyst for the financial deepening of receiving countries through higher access to banking services by migrants’ families. The entry of banks reduces the fees and increases the level of remittances, allows an optimal consumption smoothing and improves the welfare of migrants and their families, although it also increases the volatility of remittances.

Financial institutions need to provide simplicity, clarity, choice and control to woo the underbanked and non-banked into the traditional system. It is no secret that the basic challenges to financial inclusion are:

  • Coverage
  • Access to diversified financial products and services
  • Delivery model – day to day transactions

Once implemented, the Unique Identification Number (UID) Project of the Government of India will be a powerful instrument for helping the poor establish their identity to meet the banks’ KYC norms. This will reduce cash and non-cash transaction costs, both to the banks and to the potential customers.

“We cannot have depth in the market if the number of participants in the market place is not increased and that is why financial inclusion is related to financial deepening. We have to create an appropriate platform using technology and devise innovative products. The entire financial inclusion exercise is in mission mode so that we can achieve our ambitious goals”
K C Chakrabarty

Banks need to redesign their business strategies to incorporate specific plans to promote financial inclusion of lowincome groups treating it both as a business opportunity as well as a corporate social responsibility. They have to make use of all available resources including technology and expertise available with them as well as the MFIs and NGOs. It may appear in the first instance that taking banking to the sections constituting “the bottom of the pyramid”, may not be profitable but it should always be remembered that even the relatively low margins on high volumes can be a very profitable proposition.

Finance Minister Pranab Mukherjee has also urged public sector banks to increase their Kisan Credit Cards across the country by 20 per cent in 2010-11, both in terms of the number of accounts and the amount disbursed. Under his leadership, the government has set a target to provide banking facilities to areas with population above 2,000 by March 2012.

Greater co-operation between banks, policy-makers, nongovernmental organisations and technology providers is vital to improve access to financial services for the unbanked. The involvement of all stakeholders also implies the state administration at the grassroots level. As defined in these pages earlier, “Financial inclusion is fair, timely and adequate access to financial services that include saving, credit, payment and remittance facilities at an affordable cost, and in a transparent manner through institutional agencies.” To ensure, this, there is need to deepen the financial sector and reposition it for growth and integration into the global financial system in conformity with international best practices. In sum, financial sector development or ‘deepening’ involves the design and implementation of policies to intensify the degree of monetisation of the economy through increased access to financial institutions and services, their transparent and efficient functioning, and ensuring reasonable rates of return in real terms.

Spearheading the Inclusion Agenda

Finance Minister Pranab Mukherjee’s drive to increase the spread of banking services in the rural and far-flung areas is part of his more comprehensive agenda aimed at financial deepening

“Banks need to leverage modern technologies to provide banking and financial services to the rural populace and thereby create hitherto unprecedented economic opportunities for them. Financial inclusion and the extension of financial services to every citizen of the country is a priority for the government.”
Pranab Mukherjee

‘Last mile credit delivery’ appears to have become the new mantra that the UPA Government is spearheading and leading it in this march is Finance Minister Pranab Mukherjee. In fact, the agenda becomes clear if one looks at the manner in which the report card on completing the first 100 days of its second tenure is structured.

The report has been organised around 12 themes, starting with enabling human development, which focuses on education, health, child rights, social inclusion, food security, empowering women, empowerment and development of weaker sections,) an inclusive agenda for the minorities, and financial inclusion. These are all areas that are critical to its goal at promoting financial deepening.

For Pranab Mukherjee, deepening financial inclusion “To reach the benefits of banking services to the ‘Aam Aadmi’, the Reserve Bank of India had set up a High Level Committee on the Lead Bank Scheme. After careful assessment of the recommendations of this Committee, and in further consultation with the RBI, it has been decided to provide appropriate banking facilities to habitations having population in excess of 2000 by March, 2012,” he told parliament in his budget speech.

Reiterating Prime Minister’s pledge to give the country an effective, purposeful and responsive government, Mukherjee is leading the government’s efforts to seek new frontiers and new directions that strengthen the country’s social and economic foundations.

Addressing a joint meeting of chief ministers of central and west zone states and the heads of public sector banks and financial institutions in June this year, Mukherjee asked them to make serious efforts to improve the credit flow to housing, weaker sections and minority communities. “Though efforts are being made to improve the credit flow to housing, weaker sections, minority community and education loans, the credit growth in these sectors need closer monitoring in the state level bankers committees,” he said.

Mukherjee also emphasised that the financial inclusion plans for coverage of all habitations with banking facilities must be closely monitored. The statement of intent that lists annual goals that public sector banks sign with the government will have to indicate the targets for furthering financial inclusion and the time required to achieve the goals. While banks have been formulating their inclusion plans for some time now, it was Mukherjee who came out with a definite timeline for their execution.

Similarly in a meeting with the Chief Ministers of the north zone states and head of banks that have the lead bank status in the region, Mukherjee voiced his concern on matters that relate to the efficiency with which the banking system interfaces with the common man, the small farmer, students and micro entrepreneurs so as to ensure timely credit to the poor and the marginalised.

Mukherjee’s drive to increase the spread of banking services in the rural and far-flung countries is part of his more comprehensive agenda aimed at financial deepening. Delivering the inaugural address at an international workshop on ‘delivering financial literacy: challenges, strategies and instruments,’ organised jointly by the RBI and the Organisation for Economic Cooperation and Development (OECD), Mukherjee observed that “financial markets now offer complex choices to consumers, but literacy is essential for consumers to make informed choices.” According to him any effort to improve literacy should take into account India’s “divergent and multi-lingual framework”. The wide divergence in literacy levels across states and within states, the marked differences between rural and urban areas are also important issues.

The government has already started channelling more welfare payments through banks, including the payments made under the Mahatma Gandhi National Rural Employment Guarantee Act, its flagship scheme. This is expected to promote access to banking services to a larger number of the excluded. This, Mukherhee, feels will ensure equitable growth, enabling the people to derive the benefits of various government social security sch

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