A new realm
India is transitioning into a dynamic ecosystem offering fintech startups a platform to potentially grow into billion-dollar unicorns. From tapping new segments to exploring foreign markets, fintech start-ups in India are pursuing multiple aspirations. Th
In its wake of boosting financial inclusion, fintech may also give rise to regulatory concerns. N Sawaikar, Welingkar Institute of Management, shows how to achieve a balance for a more inclusive and sustainable future.
Although the term ‘financial inclusion’ became the focus of discussions in India only in the last decade, the underlying issue has been an important concern for more than 50 years. In the 1950s and the 1960s, there was a wide-ranging debate on how to make the Indian banking system more responsive to the country’s economic development needs and to the needs of the unbanked. The end result was increased state control of banking, culminating in the nationalization of banks in 1969 and 1980, as well as stringent regulations forcing banks to lend to priority sectors such as agriculture and small enterprises.
These policy initiatives have only been a partial success at best. While successfully pushing Indian banks to expand in new directions, they increased political interference and financial repression which harmed the broader economy. The economic liberalization of the 1990s significantly reduced state control over banking and expanded the role of the private sector, but even today state ownership and regulations are extensive. At the same time, financial exclusion persists and hundreds of millions of Indians lack access to services such as savings, insurance, and lending.
A major reason for this failure is the cost structure of traditional banking. A bank incurs significant fixed costs before it can offer its services—it needs to build a physical branch and hire staff and managers. Also to remain viable, it needs enough revenue to cover these costs which is often difficult in rural areas.
Secondly, accessing financial services typically requires documentation starting with the proof of identity. This is difficult to produce for the majority of Indians working in the informal sector. Difficulties may range from a lack of literacy skills, problems navigating the bureaucracies which issue documents, and a lack of safe places to store important documents. Urban migrant workers may also struggle to provide proof of address. As a result, the poor are forced to either forego financial services or rely on informal sources such as moneylenders who charge much higher rates of interest.
This financial exclusion exacts a steep human cost. A villager trying to collect a subsidy or government wage may have to waste a whole day traveling to the nearest bank branch and lose a day’s wage. A rural migrant, working in a city, may not be able to open a bank account and may have to rely on expensive and unreliable methods to transfer money to his or her family in the village. A farmer, who is unable to obtain crop insurance, may have to minimize risk by planting relatively safe subsistence crops instead of riskier but more profitable cash crops.
Fortunately, in the last ten years a new technologybased path to financial inclusion has emerged, made possible by the rapidly falling costs of information technology and the dramatic spread of mobile phones. This path is built around the insight that most financial services are about managing information of one type or another— establishing identity, assessing creditworthiness, pricing risk, etc. If information technology can be harnessed to process, analyze, and transmit financially relevant information more efficiently, it can dramatically reduce the cost of providing financial services which in turn will drive inclusion.
The recent demonetization of R500 and R1000 rupee notes has made the involvement of financial technology, especially in electronic payments, even more urgent. The sharp contraction of the monetary base has led to a decline in economic activity, particularly in the cashdependent unorganized sector. At the same time, it provides strong incentives, at least in the short run, for people and businesses to switch to electronic payments. Companies like Paytm have expanded their marketing efforts aggressively and there are reports of sharp increases in enrollment for their services. However, there are still enormous constraints in expanding electronic payments to low income groups—particularly in rural India—network connectivity, technological knowhow, trust, etc. And these problems need to be tackled with renewed urgency.
Over the last decade, several key enablers for technologybased financial inclusion have fallen in place in India. First, there has been a rapid expansion of mobile telephony with more than one billion subscribers, including more than 200 million smartphone users and more than 300 million mobile internet users.
Second, the Government of India has developed ‘Aadhaar’, a 12-digit biometrically linked unique identity number which has been issued to more than a billion residents. A act allowing for the use of Aadhaar numbers for the delivery of subsidies and services was passed in 2016.
Finally, there has been a big increase in the number of basic bank accounts, especially in rural India. In 2005, the RBI introduced the concept of no-frills accounts with nil or very low minimum balances and low transaction charges. In 2014, the government launched the Pradhan Mantri Jan Dhan Yojana (PMJDY) under which 250 million bank accounts were opened and 190 million RuPay debit cards were issued over the last two years.
All these three enablers have come together to form what has been called the ‘ JAM Trinity’—Jan Dhan Yojana, Aadhaar, and Mobile—which has allowed the government to transfer money to the accounts of the poor much more efficiently than before. This is important because the government spends more than 4% of the GDP on subsidies for food grains, fuel, fertilizers, etc. and also makes wage payments through its programs like MGNREGA.
JAM will allow the government to better the target subsidies to the poor by providing a reliable method of establishing identity. By transferring money to bank accounts directly, JAM also cuts out the middlemen so that beneficiaries can receive the full amount.
While the progress made so far has been impressive, some hurdles remain. Many of the bank accounts created through Jan Dhan Yojana have low balances and little usage. Another major issue is the ‘last mile’ problem— even if the government can efficiently transfer money electronically to recipients’ bank account, it may be difficult for those in rural areas to collect the cash.
One solution is through the existing business correspondent network of third-party agents who carry out transactions in rural areas, perhaps using micro-ATM devices that can authenticate identity using biometrics. However, the logistics of transporting and managing large amounts of cash in rural India still remains a formidable problem.
An alternative is a cashless money transfer system like M-Pesa which was launched by Vodafone in Kenya, which allows users to transfer money through their mobile phones. An important step towards mobile money transfer in India is the UPI (Unified Payment Interface) which allows money to be transferred between any two bank accounts using a smartphone and the Aadhaar number.
Payments and basic bank accounts are comparatively simple services and relatively easy to digitize. Insurance and lending are more complicated and require long-term relationships between the financial institution and the client, and have deeper informational requirements.
For lending, the fundamental problem is assessing the creditworthiness of the borrower which, in traditional banking, requires an experienced loan officer and a long drawn process. The challenge is to replicate this process in a more efficient and cost-effective way using information technology. For example, First Access, a data analytics company, has worked with mobile network operators in East Africa and used mobile phone histories to provide credit scores to low-income borrowers who lack a formal credit history.
A related approach is peer-to-peer lending (P2P), where an online platform acts as an intermediary between borrowers and lenders, and charges a fee for the service without holding the loans on its books like a conventional bank. While the P2P platform may provide some analysis about the borrower, the final decision and risk lie with the lender. This model seeks to use information technology to reduce the costs of intermediation between borrowers and lenders so that borrowers would pay a lower rate and
lenders earn a higher rate. The P2P model also has the potential to increase lending to farmers, small enterprises and other underfinanced sectors.
Technology can also improve the operational efficiency of sectors such as microfinance which lend to the poor but often use paper-intensive processes that require loan officers to visit far-flung rural areas before sanctioning a loan. Companies such as Artoo work with microfinance institutions and improve their processes through biometric verification, paperless processing, and analytics.
Closely linked to microfinance is microinsurance wherein, for example, small farmers may be provided crop insurance to protect them from deficient rainfall. Traditional insurance models that require expensive farm visits do not work in developing countries where the farmers can only afford a premium of a few dollars. Syngenta Foundation, an NGO, pioneered an alternative approach by teaming with microfinance lenders and seed companies in Kenya to bundle low-cost insurance plans with their products. Instead of farm visits, they used satellite data and automated weather stations to decide when to pay out money, which was done through mobile phones.
Startups and NGOs are good at experimenting with new technologies and business models but scaling up these new ideas efficiently is often done best by large commercial organizations. Banks and other financial companies are of course important but large companies from other sectors such as telecom and retail can also play a valuable role in this space.
Telecom companies are already important in financial inclusion because of their vital role in communication services but their large distribution networks and expertise in data analysis make them specially suited to provide financial services directly. Vodafone is a pioneer in this area and its M-Pesa service launched in 2007 has moved beyond money transfer into services like international remittances, saving, and borrowing.
Ecommerce companies too have highly relevant expertise in payments and data analysis. Alibaba, the Chinese ecommerce giant, has been successful in expanding into financial services through its online payment platform Alipay. In 2013, Alipay allowed subscribers to invest in a money market mutual fund. Alibaba also created AliFinance which provided loans to vendors on its platforms and also created its own credit scoring model by analyzing online usage patterns.
India Post is another non-financial organization with a major role in financial inclusion. With its massive network of 150,000 offices, 90% of which are in rural areas, it is especially well placed to solve the ‘last mile’ problem in rural India.
The RBI has recognized the potential of such nonfinancial organizations, and has developed the concept of payments banks that are allowed to accept deposits up to
R1 lakh, and can distribute mutual funds and insurance products though they are not allowed to offer loans or credit cards. Telecom companies such as Airtel and Vodafone, ecommerce companies like Paytm, and the Department of Posts have obtained licenses to start payments banks.
threat or opportunity?
Are these new technologies a threat or an opportunity for traditional banks? Perhaps, a bit of both. In the short term, they make it possible for banks to greatly expand their customer base and offer a deeper set of financial services at a lower cost. New institutions such as payments banks may be a complement rather than a substitute, and the new customers they attract may eventually move to traditional banks to use their richer set of services.
However, in the long run, as new business models like peer-to-peer lending mature and consumers become more
used to using financial services online, banks may find themselves getting gradually eclipsed. The key for banks is to closely follow new trends in financial technology, exploring possible opportunities for cooperation while also staying alert to competitive threats. A good example is State Bank of India which has started a R200 crore fund to invest in financial technology startups.
Similarly, financial technology creates some new concerns for governments and regulators. One set of concerns is around the potential control of data by a small group of companies. Globally, technology companies such as Google and Facebook have built extraordinarily successful business models around collecting enormous amounts of data about consumers in return for providing a rich set of services. One concern about this model is the impact on consumer privacy. Another is that these enormous data sets will become a barrier to entry for newer companies, allowing technology giants to preserve their monopoly indefinitely into the future.
A similar concern exists with financial technology. There are economies of scope in data, so the more data sources are pooled together, the richer the insights that are possible. However, if this data is controlled by a small group of companies, it can be a threat to both competition and privacy. The challenge for the government is to build a regulatory architecture for data which allows many competing companies to tap into rich data sets in order to deliver financial services while at the same time minimizing the loss of consumer privacy.
Another major concern is cybercrime and cyberwar. As more and more financial services are digitized and networked, they become vulnerable to criminals who want to steal money and hostile powers which may want to disrupt the economy by triggering a financial crisis. The government needs to develop the highest level of technological capabilities within its ranks to monitor and neutralize such threats.
Ultimately, however, the threats are dwarfed by the opportunities. Practically every sector of the economy can benefit from the expansion of financial services through technology.
Low-income savers will have a wider range of savings products and will be less likely to buy gold or just stuff cash under a mattress. These savings can be channeled by the financial system into productive capital accumulation, including infrastructure which will drive economic growth.
Small enterprises in the unorganized sector—which are starved of funds—will develop a digital trail, making it easier for them to access loans and other financial services. The best of them will expand creating millions of jobs.
Farmers will gain better access to loans and insurance allowing them to increase returns by taking calculated risks and investing in agricultural technology. Digitization of land records will strengthen land markets and make it easier to use land as collateral.
Finance is the lifeblood of the economy and the more channels it flows into, the more it will enrich the different corners of the economy. ■
The recent demonetization of R500 and R1000 rupee notes has made the involvement of financial technology, especially in electronic payments, even more urgent.
JAM will allow the government to better the target subsidies to the poor by providing a reliable method of establishing identity.
With its massive network of 150,000 offices, 90% of which are in rural areas, India Post is especially well placed to solve the ‘last mile’ problem in rural India.
The enormous data sets will become a barrier to entry for newer companies, allowing technology giants to preserve their monopoly indefinitely into the future.