EconomyInclusionPast IssuesWhither Financial Inclusion

Credit Culture Needs a New Direction

“We need smaller banks that can serve local populations. They will help the cause of SMEs far more than setting up a branch in remote areas. Of course, we need better supervision, better capital standards, etc., for these banks. In rural areas, nationalised banks are trusted because people identify them with the government.”
Raghuram Rajan, Chief Economic Adviser, Ministry of Finance.

Financial inclusion should not be measured by the number of new enterprises created. The whole financial inclusion industry has essentially propagated a myth that by giving credit to the relatively unprepared individual, you create somebody who is capable of running a business, and thereby nurture entrepreneurship. Yes, there are some areas where this can be done. For example, a woman who buys a saree and resells it in installments to her friends or a kirana shop-owner who uses credit to expand his inventory can make more money. But, by and large, people who get credit do not use it to start new enterprises. For those who do start businesses, the large-scale focus on credit does a disservice to that business as it potentially leads to issues like over-borrowing.

The fact that most credit being given is used for consumption and not for income-generation purposes is not necessarily an indictment of micro-credit or microfinance. Offering timely credit to a poor woman whose son needs medical attention is a very important benefit in terms of the livelihood that is created. Consumption can go overboard if the credit is taken to finance a lavish wedding. A lot of micro-borrowing goes into paying school fees because one can’t afford the lump sum fees, paying for medical services, etc. Studies show that the effect of micro-credit is not necessarily income enhancing but more importantly in income smoothing, in making people more capable to buy goods or services that they cannot otherwise afford.

Hiching Quam, professor at MIT, has compared micro-enterprise creation in local towns and villages in China and India. He found that one of the big factors aiding the growth of enterprises in China is the high school education at village and town levels. India needs to improve the capabilities of people through means such as education and skill-building in order to make it possible for them to acquire micro-credit and use it in ways that lead to income and livelihood generation.

It would be good if the credit being disbursed was used primarily to create more micro-enterprises, but that implies some level of handholding by the financial sector as well as an immense increase in services outside the financial sector. In terms of delivery of SME credit, an important consideration is the kind of structure which gives this credit. Clearly the point is that we need something more than business correspondents. The structure of large banks that we have today is a disadvantage when it comes to offering micro-credit.

Small, microfinance institutions play an important role here. They are much closer to the customer and can be more flexible in their dealings. They can serve and alter their products to the needs of the customer and, therefore, they have a market. Large banks are relatively bad at giving customised loans. They are not good at dealing with the timeliness of the need of the small local customer. This is why I have been a big proponent of local area banks. We need smaller banks that can serve local populations. They will help the cause of SMEs far more than setting up a branch in remote areas. Of course, we need better supervision, better capital standards, etc., for these banks. In rural areas, nationalised banks are trusted because people identify them with the government. But the difficulty is, while they enjoy trust, service levels in rural areas is not the best.

There is this misconception that small businesses are the source of job creation. They do create jobs, but they lose as many jobs as they create because many of them go out of business. The real source of job creation is when small businesses grow big

There is this misconception that small businesses are the source of job creation. They do create jobs, but they lose as many jobs as they create because many of them go out of business. The real source of job creation is when small businesses grow big. By lending to SMEs to help them get successful, small local banks can really benefit. When you lend locally, you can also grow with the enterprise to which you lend. Small microfinance institutions should grow into bigger microfinance institutions and eventually become banks. You will have failures. But a few successes will be a source of a lot of business.

One of the big issues in microfinance in India is the credit culture. It is extremely important that we develop a credit culture that is strong and effective. People should know that when they borrow they have to give it back. Sustaining a credit culture basically means not using credit as a back-door entry for fiscal transfers, but making fiscal transfers directly and treating credit as a standalone entity.

Raghuram Rajan

Raghuram Rajan is Chief Economic Adviser, Ministry of Finance.
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