Expert’s View

Policy Dichotomy between Financial Inclusion & Financial Stability: Role of Regulaory Standard Setting Bodies. By K.C. Chakrabarty, Deputy Govenor, Reserve Bank of India.

Financial Inclusion is a critical policy imperative for all countries, more particularly, the developing world. Concomitantly, post the global financial crisis, financial stability has also emerged as one of the core focus areas for policy makers worldwide. The key challenge is to ensure that the goals of financial inclusion and financial stability are accorded adequate priority while framing macro policies and implementing strategies.

The imperatives of pursuing the objectives of financial inclusion and financial stability are evident, but they do raise certain questions. Let us begin by unraveling some conundrums. Is there a policy dichotomy between pursuit of the two objectives? Are there risks to financial stability from pursuing greater financial inclusion or is the pursuit of financial stability inimical to the goal of more widespread financial inclusion?

The synergies and trade offs between financial inclusion and financial stability has been a subject of debate in various fora. What is clear, however, is that the two must co-exist. It is difficult to envisage a stable financial system in the long run if a large segment of the population remains financially excluded. At the same time, it is hard to envisage the continued success of financial inclusion initiatives unless banks and other financial institutions remain healthy and the financial system remains stable.

Concerted efforts are underway, especially in developing and emerging economies, to expand the reach of basic financial services to a wider section of the society. The quest for inclusive growth draws from a powerful lesson of development experience- that growth has no meaning, or indeed, no legitimacy, if those at the bottom of the pyramid are left out. In India, we have embarked on a massive Financial Inclusion initiative to bring banking services to the doorstep of people in all the 600,000 villages. Till date, we have reached 200,000 plus villages. Concomitantly, financial stability, as a goal, has, for long, been pursued in the Indian context, either explicitly or implicitly. In 2004, the Reserve Bank formally added financial stability as an additional policy objective, in view of the growing size and importance of the Indian financial sector.

Beyond the pursuit of financial stability and financial inclusion as separate policy objectives, the synergies between the two were formally recognised with the establishment of the Financial Stability and Development Council (FSDC) in 2010 with a mandate to promote, inter alia, both financial stability and financial inclusion. The FSDC is an inter agency forum of the financial sector regulators and the government, chaired by the Finance Minister.

The experiences drawn from the global financial crisis suggest that the risks of disruptions to the financial system and their potential impact have not been fully understood. Post crisis, led by G-20 and the regulatory Standard Setting Bodies (SSBs) viz. Financial Stability Board, Basel Committee on Banking Supervision (BCBS), Committee for Payment and Settlement Systems (CPSS), OECD, IMF, World Bank etc, a monumental regulatory overhaul is being attempted to address the deficiencies.

Even as the regulatory SSBs strive to establish an enduring framework for promoting financial stability, the role of these entities in ensuring more widespread and effective financial inclusion is very critical. Are the policy makers cognizant of this larger responsibility? The answer to that has to be a qualified ‘yes’.

On the one hand, the standard setters are working together to integrate financial inclusion into standards and guidances that can be effectively applied at the country level. However, financial inclusion’s focus on large numbers of low income individuals presents challenges to the traditional notions of SSBs. The ground realities in developing countries, which are home to more than 90 per cent of the world’s “unbanked” or “financially excluded”, are quite different from those in more financially developed countries. The G-20 Leaders recognize these issues and encourage regulatory SSBs to explore complementarities between financial inclusion and their core mandate.

It must be recognized that financial inclusion, by itself, can provide a great impetus to financial stability. Provision of financial access would move the excluded masses away from the informal financial system or the shadow banking system into the fold of the mainstream regulated financial system. Through efforts around financial inclusion and financial literacy, policy makers are trying to influence the financial habits and preferences of the unbanked masses by encouraging them to adopt formal financial products. One can imagine the impact a few billion new banking customers can have on the global financial system, particularly that of emerging economies. The enhanced depth of these financial markets would, by itself, make them much more resilient to financial shocks, thereby augmenting financial stability. With significant expansion in the size of financial markets in emerging economies, they could prove to be an effective counterweight to the sophisticated financial systems of the developed economies. This could also, potentially, limit the domino effect of any future financial crisis originating from the developed world.

Likewise, the synapses of a healthy financial system, smoothly functioning financial markets and efficient financial market infrastructure – all essential components of a stable system – can significantly contribute to greater financial inclusion. After all, it is difficult to envisage how banks and financial institutions can mobilize resources and efforts towards financial inclusion amidst financial turmoil. A 2010 report of the World Bank[1] has observed that during the peak crisis period of 2009, worldwide volume of deposits and loans shrank, with a median decrease of 12 percent in the ratio of deposit value to Gross Domestic Product (GDP) and a median decrease of 15 percent in the ratio of value of loans to GDP.

Against this backdrop, this article flags certain larger concerns that would need the attention of the SSBs to help country level policy makers balance priorities as they pursue a broader agenda of financial inclusion and financial stability.

1. A) Impact of FATF standards on Financial Inclusion

The starting point of Financial Inclusion is the opening of a basic savings bank account for all individuals. However, herein lies a delicate balancing act – establishing a KYC framework that facilitates financial inclusion and yet, does not render the financial system vulnerable to exploitation. The aim should be to prescribe a ‘doable’ KYC for small accounts or else people will continue to deal in cash. With large sections of the global population remaining outside the banking system, the case for a stringent KYC regimen, even for small accounts, is not tenable. Frequent movement of people within a country, migrations within the continent and across the globe is going to be a reality on account of uneven growth and other demographic factors. If KYC formalities are not liberalized, these migrant workers cannot be brought within the ambit of the formal financial system.

While the Risk Based Approach (RBA) adopted by FATF recently is welcome, doing a risk assessment and conducting Customer Due Diligence (CDD) for millions of low value accounts being opened through the financial inclusion process, is not only a waste of scarce financial and human resources, but also goes against the broader FATF goal of weaning people away from the cash economy. The priority, therefore, has to be to bring the excluded people into the formal banking system by opening their accounts in a camp mode, without detailed documentation. As and when the transactions in these accounts grow beyond a threshold, identity and proof of residence could be obtained. Similarly, small value remittances need to be permitted for all walk-in customers.

What is being emphasized is that KYC requirements are not to be waived altogether, but requirements of stringent documentation need to be liberalized and other options like biometric identification and self declarations, etc. need to be encouraged at the initial stage.

1. B) Impact of Basel Norms on SME and Infrastructure Financing in Emerging Markets

Another vulnerable group is the Small and Medium Enterprises (SME) segment. Though lending to SMEs had little to do with the financial crisis of 2008–09, the credit crunch and subsequent economic slowdown have hit smaller enterprises hard. SMEs are the growth engine of all economies and hence ensuring uninterrupted finance to this sector is of critical importance. The providers of finance to SMEs in emerging market economies are mostly home-grown banks with little international presence. Although the small lending institutions had proved to be a factor of stability during the crisis, Basel III regulations are meant to apply equally to even such banks. Blanket application of the Basel III regulations to the smaller banks could, in the medium term, jeopardise the stability of SME financing and, thus, economic recovery.

A related issue in the context of the Basel III reforms is of their uniform implementation across all jurisdictions and geographies. It is evident from the experiences during and after the crisis that banks in developing economies were not afflicted by the same weaknesses that had plagued the banks in the developed world. Hence, the case for parity in implementation of reform measures needs to be evaluated in greater detail than has been done so far. This is, particularly, important given the compulsions of financial inclusion in these economies.

Another specific concern around Basel III norms is that the higher capital requirements would come into force when credit demand in the Emerging Market and Developing Economies (EMDEs) like India will be on the upswing, owing to several reasons. First, Financial inclusion will bring millions of low income households into the formal financial system with almost all of them needing credit. Second, in most of the structurally transforming EMDEs, the need for investment in infrastructure will necessarily increase at a very rapid pace. It is well acknowledged that infrastructural development is key to a tangible and sustainable inclusive growth. In the absence of a deep corporate debt market, the commercial banks in these countries are invariably the sole source of long term finance to the capital intensive infrastructure sector. Besides, the impact of changing regulatory environment may be further accentuated by recent proposals to impose stricter single and group borrower limits on banks’ large exposures. In the EMDEs like India, such steps could severely restrict the access to bank finance for large entrepreneur groups with potentially significant downstream impact on investment and economic growth.

The moot point, therefore, is how much growth could we be willing to sacrifice in order to buy the ‘so called’ insurance against financial instability? A report prepared by the Financial Stability Board in coordination with the staff of the IMF and the World Bank[2], highlights the potential adverse impact of implementation of the reform measures on emerging markets. Surely, the effect of stricter capital and liquidity requirements on nearly half of the world’s economic output and more than two thirds of the world’s workforce needs to be carefully assessed and capital norms, risk weights and liquidity ratios for SME, trade and infrastructure credit need to be carefully calibrated. While speculative and consumption credit merit higher risk weights and capital requirements, in case of credit for productive purposes to smaller borrowers/SMEs, the risk weights should not be placed on an equal footing. It is imperative that individual jurisdictions have the discretion to apply regulatory norms in tune with country specific priorities. In fact, non-calibrated and strait-jacketed implementation of the regulatory reform measures, including Basel III, is likely to lead to subdued growth in the EMDEs and thereby, have a destabilizing effect on the entire global economy.

1. C) Cross border Remittances

Another area that needs the attention of regulatory SSBs is cross border remittances. Globalization has made the world flat. The number of migrants is increasing considerably and consequently, cross-border remittances are also expected to grow rapidly in EMDEs, which have great potential for promoting financial inclusion. Harnessing remittances for financial inclusion will necessitate addressing four major challenges: (i) reducing remittance transfer costs; (ii) opening up formal channels; (iii) channelizing remittances to savings and investments; and (iv) maximizing their benefits to both migrants and recipients. Cross-border collaboration among financial service providers can help link remittances to other financial products for migrants’ families in their home economies. For facilitating this, the SSBs need to engage with individual jurisdictions to develop standards and protocols that support growth of cross-border remittances, particularly small value transactions, while ensuring that the integrity of the system is not compromised by rogue large value transactions.

1. D) Impact of Context Specific Core Principles on Financial Inclusion

The expectation from large multinational banks is that they would facilitate financial inclusion in the developing economies by leveraging their global experience and introducing innovative banking products and practices. However, since these large banks have been averse to fulfilling this expectation, the role of smaller regional/ national banks becomes vital for ensuring financial inclusion. In this context, an important issue that needs to be debated by the BCBS is how the core principles can be applied to cooperative banks, rural banks and other mid-size domestic banks which are focused on providing finance to vulnerable sections like farmers, small entrepreneurs, etc, vis-à-vis the large multinational banks. This is an important consideration as there is a general tendency among member countries to simply copy the regulations from BCBS or from other compliant countries, which even defeats the purpose of providing context or situation specific flexibility to individual countries by the SSBs.

1. E) Expectations from Payment Systems Standards

With regard to the payment systems, the issues grappling developing countries vary from those where financial markets are developed and focused on systemically important payment systems. The core principles also need to focus on large users- small value payment systems. The learnings need to come from other peer countries’ payment system models. The CPSS can study the evolving systems in developing countries and can come out with best practices of greater utility to developing countries.

1. F) Unilateral measures-Role of SSBs

One issue which has been engaging the attention of policy makers globally is that of the extra-territoriality of reforms. The issue relates to the unilateral requirements imposed on the banking companies of all countries, coupled with prescription of unrelated punitive measures in case of non compliance of provisions like the Foreign Accounts Tax Computation Act (FATCA). There is a need for the multilateral SSBs to address these issues and evolve core principles after due consultations with all stakeholders, especially those from the emerging markets. The apprehension is that if banks, with severe resource constraints, get bogged down in the myriad of administrative formalities, without any commensurate or proportionate gain, then the most likely sufferer would be the person at the bottom of the pyramid. The larger apprehension is of other countries taking similar unilateral actions.

Conclusion

The article attempts to flag a few of the issues which need to engage the attention of regulatory SSBs if any policy dichotomy between financial inclusion and stability are to be addressed and if the objective of inclusive growth with stability is to be achieved. These issues are of critical importance globally and, especially, for emerging and developing economies. The stability and desirability of the emerging post-crisis global financial system would be determined by how these objectives are balanced and, indeed, synergized through appropriate policy support and regulatory impetus. The regulatory SSBs need to take a lead for this to happen.

[1] “Financial Access: The State of Financial Inclusion through the Crisis”, Consultative Group to Assist the Poor /The World Bank Group, 2010

[2] http://www.financialstabilityboard.org/publications/r_120619e.pdf