The Union government recently launched a massive financial inclusion programme with a view to improve access to formal finance. In this context, it is crucial to understand not only the importance of universal access to formal finance, but also the effective ways of achieving the same.

Peer-reviewed and econometrically-careful academic research has shown that a programme that nudges households to open bank accounts increases their dealing with the formal financial system. More importantly, research has pointed out that such effects tend to persist for longer periods of time. However, in the presence of many types of constraints such as lack of awareness, poor infrastructure, law and order issues, etc, access to finance may not be enough for achieving the goal of alleviating poverty. Nevertheless, this is a good beginning towards addressing one important problem.

It is not very hard to convince people that lack of access to formal finance is a real problem plaguing the poor in India. If one steps out of home and interviews street vendors, some startling numbers are revealed. A vegetable vendor that I spoke with has the following business model: Borrow R900 in the morning; buy vegetables; sell them; return R1,000 to the lender and keep the balance, if there is any, that is. In other words, he borrows at 11.1% a day. At this rate, obligation doubles approximately every five-and-a-half days! You will hear similar stories from poor people who get admitted to private hospitals after being told by government hospitals that the required facilities are not available.

Before jumping the gun on the ruthlessness of the lenders, it is better to understand the reasons why poor people do not have access to formal finance and, hence, are forced to borrow at exorbitant rates. Standard economic theories work well in settings where information is seamlessly and perfectly available. However, in the case of poor borrowers, a bank does not have credible information about them: such borrowers neither possess formal documents such as tax returns nor do they have any track record with the bank. This makes it impossible for the bank to distinguish between a good and a bad borrower and, thereby, price the loan effectively. Charging a very high rate is also not feasible?there is a danger of moral hazard kicking in. In other words, if a bank charges a very high rate, then the borrowers may not have enough equity in the project that motivates them to work hard. A bank cannot compel the borrowers to work hard as it cannot verify the effort level of the borrowers. Moreover, the political economy of India constrains banks in their recovery efforts. In such a scenario, banks find it appropriate not to lend to poor borrowers. Economists Joseph Stiglitz and Andrew Weiss, in their seminal research paper, call this phenomenon as credit-rationing. D McKenzie and C Woodruff show that poor borrowers, with potential marginal return of 20% per month, do not get any access to formal finance.

A money-lender, on the other hand, not only has more information about the borrowers, but is also armed with extra-legal ways of recovery. Moreover, he can monitor the borrowers better than a bank and guard against moral hazard. Due to these reasons, poor borrowers are forced to borrow from money-lenders.

Now, the question is, how to best solve this problem? One way is to force the banks to compulsorily lend. This is the ?loan mela? approach adopted in the 1970s. Such a move will result in banks being flooded with NPAs and further reduce access to finance as banks will not be left with enough funds to lend. The second, and more realistic, approach is to nudge the borrowers towards formal financial system and help them build a track record. The scheme under study falls in the second category.

Economists Shawn Cole, Thomas Sampson and Bilal Zia conducted randomised field trials in India and Indonesia to understand the determinants of financial access. They found that small nudges in the form of subsidies to open bank accounts increased the propensity to open accounts three-folds. They also found that such beneficiaries continue to use bank accounts for deposits, loans and other purposes even two years after treatment. This shows accounts can be sticky. Manju Puri, Jorg Rocholl and Sascha Steffen, after examining more than a million loans lent by 300 banks in the US, conclude that borrowers who have savings bank account with a bank default significantly less. By examining the loan application data, they show that the bank is able to better screen and monitor such borrowers as it has information about them. In short, even a savings bank account history can work as credible information source for the bank.

The latest scheme allows banks some time before they start giving out the overdrafts. This, I feel, is the most attractive and practical aspect of the scheme. Thanks to this scheme, a number of borrowers now have a chance to develop track record with the formal financial system. This can potentially solve credit constraints for a large number of borrowers.

In sum, I think this is a progressive scheme which may have a significant impact. However, in the presence of other constraints as described above, expecting this scheme alone to solve the problem of poverty is wishing a bit too much.

Prasanna tantri

The author works for Center For Analytical Finance, Indian School of Business