Financial inclusion encompasses broadening access to financial services, deepening and improving the quality of services to those who have access, and increasing financial literacy and consumer protection. As is well known, there are informal sources of financial intermediation, but these can be costly and inefficient. One of Governor Rajans main themes was that information technology can reduce the costs of financial services, allowing inefficient providers to be replaced, and increasing access in this manner.
Some costs are technological, and here information technology plays an obvious and direct role, allowing cumbersome paper-based and manual methods to be replaced by automated electronic mechanisms. But information technology also has a powerful indirect role to play by allowing the creation of reputations in the market for credit. Currently, such reputation mechanisms for creditworthiness are sorely underdeveloped in India. The problem is not just cost or technology. The transactions that would allow such reputation building to occur do not take place, or are hidden from view in informal markets.
What is required is a systemic approach to reform, and RBI has a major role to play in this process. Till recently, RBI has tended to put safety and stability ahead of financial development, but technology has made that a false tradeoff, and there is considerable catching up to be done. Governor Rajan highlighted several areas for progress. One is having more reasonable know your customer rules, to allow more initial entry into the formal financial system. Another is agreement and collaboration among a range of financial institutions (especially banks, but possibly new, specialised institutions) and telecom operators for mobile-based financial transfers. RBI can play an important role in helping disparate institutions jointly develop the needed infrastructure, not least by providing regulatory clarity.
Financial inclusion is often taken to refer to services for households, but perhaps the most important place to start is small business finance. In my Financial Express column of April 18, 2012 (http://goo.gl/eUKuMZ), I had highlighted the importance of short-term borrowing for smaller firms. India has very poor markets for firms to borrow against, or sometimes sell, illiquid and uncertain assets such as accounts receivable and inventories. Governor Rajan proposes the creation of a Trade-receivables Exchange, and says RBI is in discussions with market participants. Such a platform has the potential to transform business finance in India. Indeed, one can think of using this approach for slightly longer-term financing, and for securitisation of trade credit, which is made up of idiosyncratic, heterogeneous assets.
Creating this new market should be an urgent priority, even though it is a difficult undertaking, because of the complexities of business finance. A key complement and supporting development to this market would be an information infrastructure allows firms to build credit reputations. A reputation mechanism would reward honest and competent firms, punish those that are not, and greatly improve the flow of credit. As Governor Rajan emphasises, firms financial reputations can be built on a wide array of transactions, including utility payments, and not just trade credit.
Improved mechanisms for creating and maintaining financial reputations will help banks do their job better, but also make it possible for banks to be augmented by other sources of finance or financial intermediation. In the latter case, effective, streamlined regulation will be necessary, and RBI and the government need to make sure that such regulation is put in place quickly.
There are two benefits from a new approach to financial intermediation that uses technology to reduce transaction costs and asymmetries of information. One is that existing borrowers can obtain funds more cheaply. The second is that those who were earlier excluded can now obtain finance. In the latter case, some new lenders may be able to put idle money to work. The losers will be current financial intermediaries that either operate inefficiently and uncompetitively in formal markets, or reap excess returns in informal markets.
Fixing small business finance is a great place to start improving financial inclusion. Issues of financial literacy are less of a concern. Reputations are potentially very valuable in this arena. Market structure and regulatory innovations can be road-tested and then adapted for other markets, such as credit for farmers or households. The winners will far outnumber the losers. This is a reform that is overdue and should not wait.
The author is professor of economics, University of California, Santa Cruz