Financial inclusion and the rate of interest

The Reserve Bank of India (RBI) announced on September 23, the appointment of a Committee on Comprehensive Financial Services for Small Businesses and Low Income Households, under the chairmanship of Nachiket More. Among the terms of reference is the following:
“To lay down a set of designer principles that will guide the development of institutional frameworks and regulation for achieving financial inclusion and financial deepening.”
Although the term designer principles is broad enough, I should like to point out that there is one important issue which should have been specifically included in the terms of reference, namely, interest rate. This is especially necessary because the committee is composed of, among others, international bankers like J P Morgan and CitiGroup and also domestic private sector financial institutions, like Mahindra and Mahindra Financial Services and Janalakshmi Financial Services. The private sector is not exactly known for its small borrower-friendly approach. The second strong reason why the interest rate is critical is that India has witnessed two unhappy episodes in recent financial history – episodes which clearly demonstrate how small borrowers were exploited. These relate to inequitable interest rate structure and micro financial institutions (MFIs).
In its zeal to implement the Basel norms with its attendant risk weightages, the RBI ended up in evolving a highly inequitable interest rate structure – a structure in which small income borrowers subsidised high income borrowers. A small farmer was required to pay 12 per cent interest, while a high rated corporate entity could raise money from banks at 6 per cent. It took the RBI more than a decade to realise this mistake and in the meanwhile, small borrowers suffered.
The road to financial inclusion is not always paved with good intentions. The recent crisis witnessed by the micro finance sector provides an instance of how, in the name of facilitating financial inclusion, for profit micro finance institutions (MFIs) metamorphosed into glorified moneylenders, charging small borrowers usurious interest rates of 30 or 40 per cent. The government of Andhra Pradesh deserves to be congratulated on its ordinance issued in 2010, which spelt out clearly the malpractices of such MFIs, “whereas these SHGs are being exploited by private MFIs through usurious interest rates and coercive means of recovery, resulting in their impoverishment and in some cases, leading to suicides.” What was more tragic was that public sector financial institutions and the RBI became co-conspirators in this exercise. Support to these modern Shylocks was extended from public sector banks (PSBs), NABARD and SIDBI. The support was blessed by RBI, which allowed banks to treat lending to MFIs as priority sector lending. The resources of public financial institutions were thus used to boost profits of MFIs. Even after the crisis, the RBI’s Malegam Committee has sanctified a 26 per cent interest rate for MFIs. This is most unfortunate because historically, the RBI had acquired the image of the guardian angel of small farmers or small borrowers generally.
In this context, a clearer definition of financial inclusion provided by RBI recently is welcome.
“Financial inclusion is the process of ensuring access to appropriate financial products and services needed by all sections of the society in general and vulnerable groups such as weaker sections and low income groups in particular at an affordable cost, in a fair and transparent manner, by regulated players”. The key words are “affordable cost.”
In most of the discussions on financial inclusion, we are content with emphasising only the access of the financial institution or bank. But this inclusion becomes meaningful only if it is accompanied by the rate of interest at which such access is facilitated. Otherwise, as in the case of for profit MFIs mentioned above, such access would become counter-productive. By charging an interest rate of 20 per cent or 30 per cent, to say, a micro enterprise, we are building non-viability into the enterprise from the start. Our aim should be that banks or finance companies should go beyond profit-making and try to upgrade the enterprises to which they lend – farm or non-farm enterprise and catapult the borrower into a higher income trajectory.
It is ironical that policy makers in the ministry of finance, government of India, are obsessed with lending rates to the corporate sector. Even the minister of finance does not mind publicly urging the RBI governor to reduce the lending rates to the corporate sector. But nobody raised a finger when MFIs charged 30 or 40 per cent interest to small borrowers.
I would urge that the committee should treat the interest rate as an integral part of the design principles. To repeat, access to a bank or financial institution becomes meaningful only when it is related to interest rates. This does not mean that the committee should prescribe a specific rate to small borrowers. Some range of interest rates, in relation to say, the base rate of banks, could be indicated.
In this context, a more general question can be posed. Is the financial sector inherently equity-promoting or at least equity-neutral? Governor Subbarao answers the question. “Our experience has been that left to itself, the financial sector does not have a pro-equity bias. Indeed it is even possible to argue that financial sector does not necessarily reach out to the bottom of the pyramid.” Hence the need for policy intervention.
Informal Sector
Penetrating the informal sector poses a challenge to financial inclusion. The way we look at the informal sector has also changed somewhat. So far, our assumption was that informal work was a sort of transit stage, of a temporary duration. People worked for some time while waiting to get regular jobs. Eventually, these workers would be absorbed into the formal sector. Today, some economists argue that informal work is the way to “prosperity for all.” Has it become a permanent fixture? As Jan Breman has demonstrated: “… an informal sector exists in urban and rural areas, as also the industrial sector which is usually considered formal.” Outsourcing and subcontracting have become central features of the formal sector, to avoid regulations and maximise profit. In a way, the bewildering heterogeneity of the sector is explained by this. The modalities of bringing the borrowers in the informal sector into the mainstream financial sector and the concessional interest rates, wherever warranted, should form part of the discourse on designer principles.

DR.N.A. MUJUMDAR