Financial Sector Reform for India's Masses

The draft report of the Committee on Financial Sector Reforms, chaired by Raghuram Rajan, which came out a few months ago, followed on last year's Mistry committee report on developing Mumbai as an international financial centre. The reports are complementary in their focus—on domestic and international markets, respectively—and very similar in perspective and recommendations. The Rajan committee was commissioned by Planning Commission Deputy Chairman Montek Singh Ahluwalia. Other policymakers have also been discussing the extension of financial sector reforms to the masses. RBI Governor YV Reddy, in an interview on October 31, 2007, said that “The democratization of the banking system is vital, not just provision of credit. The financial system, banking in particular, is like giving elementary school education. Therefore, the highest priority needs to be given to financial inclusion coupled with financial literacy and credit counseling.” Also in October 2007, Montek Singh Ahluwalia, in an interview with a McKinsey & Co director, made an even broader statement, in discussing the charge of the Rajan committee: “The idea is to take an integrated view of the financial system: looking at banks, capital markets, insurance, microfinance issues, and the whole issue of financial inclusion.... I think financial-sector reforms have to include things like: what’s the best financial system to make sure that farmers can get access to credit? What’s the best way of making health insurance readily available? What’s an environment in which different types of risks can be effectively countered? And how can you ensure inclusiveness in all this?”

Fortunately, while stock markets and high finance may seem to be a far cry from rural credit and crop insurance, the principles that govern the provision of financial services are the same at every level. Basically, financial services involve meeting two objectives: reallocating income across time and across different contingencies or states of nature. Heterogeneity of wants and initial endowments makes markets in achieving these reallocations possible. The inherent time delays and uncertainties associated with financial services are a major source of challenges for smooth market functioning. Hence, financial markets are always going to be subject to turbulence (to use Alan Greenspan’s term). The triumph of modern economies has been to tame this turbulence through good governance, while continually adding complexity and sophistication to financial markets.

Financial market institutions provide matching services, pre-transaction information and screening, post-transaction monitoring and enforcement, and basic transaction completion. Since these can all be quite complex, there are strong economies of specialization through training and accumulated experience, as well as simple economies of scale that arise from the fixed costs of making a market or creating a platform. These economies, as well as the benefits of reputation and (in the case of managing uncertainty) the law of large numbers, all favor the existence of financial intermediaries of various kinds.

The abstract principles just outlined apply to international financial centers as well as to remote villages. In any of these settings, if information is poor, if there are few potential market participants, if enforcement mechanisms are weak, then financial markets may be inefficient, limited, or even non-existent. The differences between the metro and the hamlet are often differences of degree and not of kind. Another very general aspect of financial markets, indeed of any markets, is that lack of competition hurts market efficiency. If either side of the market, or the intermediary, has disproportionate power, that party will earn excess returns at the expense of the less privileged market participants. This applies to village moneylenders and farmers in India, as it does to investment banks and entrepreneurs in Silicon Valley, or to the urban poor and pay-check-cashing companies in any number of US cities.

The most powerful means of increasing inclusiveness, or of democratizing finance, is to increase competition. This means not only increasing the number of providers of services, but also improving the information and capabilities of the users. The fact that many new mortgage borrowers in the US did not understand the contracts they were signing was a contributor to the subprime crisis. Dr Reddy is absolutely correct that improving financial literacy is important—though this must be seen in a context where even basic literacy is often missing. An overhaul of regulation is sorely needed, however, so that regulation is aimed at increasing disclosure, and allowing for appropriate escape clauses, rather than controlling suppliers of financial services so heavily that competition is stifled, along with all other incentives for efficiency.

Information technology is bringing down many of the costs of screening and monitoring, and is allowing new entrants to provide a wider array of financial services to rural India. Microfinance loans are being securitized and mini-insurance policies being offered. As growth trickles into rural India, the demand for financial products will increase, and the main constraints on supply are probably poor regulation and the existence of inefficient state-owned incumbents. It may be true that in the past, the state-owned financial institutions helped to get basic credit and deposit services down to the rural poor. But they have also been co-opted by the better-off, they have been wasteful and inefficient, and they have failed to innovate to meet emerging demands. Moneylenders, commission agents and other traditional rural intermediaries have continued to wield disproportionate power in markets for rural financial services. This will change with lowered transaction costs and lower entry barriers, and reform must be driven by these principles, and not introduce new controls. The Rajan committee report provides detailed ideas on, not so much the best way of making financial services more widely available and affordable, but on what the best way is, but rather on how to create a regulatory environment in which the best ways will emerge through competition and innovation.