## Sunday, October 16, 2016

### Household finance in India: The state of the art, 2016

by Renuka Sane.

Household finance studies how households use financial instruments and markets to achieve their objectives. The Reserve Bank of India has recently set up a committee to look at the various facets of household finance in India. What have we learned so far about household engagement with Indian finance? What are the barriers? What kind of portfolios do we see, if households do enter markets? In this article, we present a brief overview of the research evidence on household finance in India. We also lay out areas for future research that will feed into evidence based policy and regulation making as we move along the path of greater financialisation of the economy.

### Household finance and financial inclusion

In the popular discourse in India, household finance has been seen through the lens of financial inclusion, which has come to mean access of low income households to finance with an accent on credit and savings products. However, there is much more going on in the field of household finance:

• The first dimension is the intensive vs. extensive margin. We should be asking: What households are cutoff from formal finance, and why? And, for the households that have a non-zero engagement, what determines the depth of that engagement? Do households really use the market as much as they should, or as efficiently as they could?
• A second dimension is the range of products. This is related to the kind of products that households use. These range from credit (accessing loans through informal sources instead of formal), payments, insurance (relying on kinship networks or savings instead of insurance products in times of crisis), derivatives (risk transfer), and investment (using real estate or gold instead of financial products). In each of these areas, we need to understand what households are doing and why.
• A third dimension is the income heterogeneity. Most often, access to finance is seen as low income households not being able to access bank accounts, or formal credit. However, access to finance issues also pervade middle income and rich, rural and urban households as well.

Poor people have intermittent incomes and face high risk. They need sophisticated finance, but are very often cut off from it. Most wealth is with the rich, where faulty financial decisions at the level of the household, and failures of the financial system, can give inefficient resource allocation at the level of the country. Research on household finance, should not thus not restrict itself to the problems of low-income households. Household finance is a part of finance as a field, not just a part of poverty studies.

Research suggests that five factors shape household engagement with financial markets. These are: Supply side barriers, Knowledge, Trust, Irrationality, and Mismatch between preferences and market offerings.

### Supply side barriers

There are three kinds of barriers:

• Physical: That is, financial institutions do not exist in the vicinity of the households residence.
• Transactions costs: That is, the minimum amount required for a transaction is higher than what households can afford, or the cost of low-valued transactions is too high making them unviable.
• Documentation: That is, households do not have enough documents for formal registration e.g. KYC procedures.

Research has shown that removal of these barriers does make a difference to participation. More bank branches, door-to-door services are seen to improve the use of finance (Burgess and Pande, 2003; Ananth, Chen and Rasmussen, 2012). The design of new products such as micro-pensions and micro-insurance is making headway into both physical access and transactions costs (Sane and Thomas, 2015; Sane and Thomas, 2016).

At the same time, forcing access through coercing financial firms does not get the desired results, as staff mechanically check regulatory compliance boxes (and sometimes not even that), without really improving access (Mowl and Boudot, 2014). This experience suggests that we need more competition, and more space for innovative product structures, and company structures (such as technology platforms) that can improve on the barriers of access in an incentive compatible way.

### Knowledge

Suppose we solve the access issues. Will that be enough? Not really. The next big barrier to household participation is knowledge of products. Just because a broker or a bank exists, does not mean households will easily engage with them.

Households face knowledge constraints, both in terms of the ability to calculate their expected cash-flows and requirements over long horizons, and the understanding of the suite of products available in the market that match their requirements. The literature thinks of this as the lack of financial literacy. A huge literature has therefore developed to measure the financial literacy of households, and whether improvements in literacy lead to improvements in use of financial products - both on the intensive as well as extensive margin.

Early evidence from India shows that financial education improves take up of products (Gaurav, Cole and Tobacman, 2011), but evidence across the world is inconclusive on how effective literacy is (Hastings, Madrian and Skimmyhorn, 2012). The problem with research on financial literacy is that it can mean many things, and we don't know enough about what aspect of literacy really matters. Households across the income spectrum will also struggle with different aspects of financial literacy - a rich educated household may understand compound interest, but may still not know how to calculate the IRR of a complicated product.

Perhaps, we need to think about literacy not as numeracy, but as awareness. We need to focus on making customers know what they don't know, so that they can at least begin to ask the right questions, and seek advice.

### Trust

Households may have all the knowledge about finance. And yet, they may be unwilling to engage. Lack of trust is often claimed to be a reason why households do not access financial markets. There seem to be two kinds of trust deficits - about the advisor/distributor selling the product, or about the product itself. For example, Cole et. al., (2013) find that lack of trust was an important reason for low take up of rainfall insurance.

One way in which trust gets affected is if financial intermediaries mis-sell products, and customers become wary of anything remotely related to finance. Solving this problem is the main plank of the Indian financial reforms, where the draft Indian Financial Code places consumer protection at the heart of financial regulation.

A lot of recent research in India has focused on documenting the mis-sale of products by distributors (Anagol and Kim, 2012; Halan, Sane and Thomas, 2014; Halan and Sane, 2016). In fact, this is an area that has also received a lot of policy attention. Two Committees set up by the Ministry of Finance (Swarup Committee Report, 2009; Bose Committee Report, 2015) have identified poor regulation of distribution and advice as a key cause of mis-sales. The belief here is that because product providers pay agents, the agents work in the interest of the product provider and not the client. The advice provided by the agents, is therefore, biased.

One way to improve trust is the process of disintermediation through robo-advisory services, where the conflict of interest between advisor and client is removed through regulation of the technology companies who offer robo-advice. This can be connected to platforms like Amazon or Ebay for doing product distribution. This is a dimension where the new world of fintech can have transformative impact. However, before the fintech revolution can impact upon India, a great deal of work is required by way of financial reform.

### Irrationality

It may be that households have all the access, and knowledge they need, trust the system, and yet, are unable to make decisions in their long term interest. People forget, can be lazy, can be myopic. The behavioural finance literature has shown a lot of instances where irrationality influences participation in markets.

In India, we don't know too much about this issue. Campbell, Ranish and Ramadorai, (2013) and Anagol, Balasubramaniam and Ramadorai, (2015) have shown evidence of behavioural biases using stock market data on Indian investors. There is, however, not yet enough evidence on all kinds of households, and all kinds of financial products.

An example of irrationality that we see often in India is that the very same people who think stock markets are not to be trusted, will put their money in emu farming. How does one explain this?

### Mismatch

The discussion so far has assumed that customers are making a mistake in not engaging with the market. But perhaps, it is most rational for customers to shy away if the market is unable to provide them what they need. There may be several reasons and we speculate on some of them here:

• Perhaps formal finance is not able to deal with households, especially seemingly illiterate (financially or otherwise) households with respect and fairness.
• Perhaps households in India are extremely risk averse, and there aren't products that provide an appropriate risk-return trade off.
• Perhaps, products in the market are too rigid, and not account for liquidity constraints that households may face.
• Perhaps the tax structure is such that households end up over investing in one kind of product only for the tax break, leading to a sub-optimal portfolio allocation.
• Perhaps, several households are constrained by the need to not disclose income for fear of paying higher income (or other) taxes, and prefer to lock money in informal products.

Of course, one could ask, why does the market not respond with products designed to meet household requirements? This may come about as a combination of regulatory barriers to innovation, entry barriers that inhibit competition, and the race to the bottom with high profit rates in the hands of intermediaries who do bad things for households.

### Where do we go from here?

Improving the regulatory environment
How do we design regulatory frameworks that will foster competition and bring about innovation? How do we let the market freely design products that match customer need? How will these be balanced by the need for consumer protection? What, in the current framework needs to change? The draft Indian Financial Code has provided a blue print in terms of a principles based law on solving these issues. We need to develop a policy research agenda that helps us translate that law into regulations, and build enforcement capacity at the regulatory bodies.
Given the complexity of financial products, and low levels of financial literacy (that are likely to not get better soon), a class of intermediaries in the form of advisors will come to play an important role in channeling household savings to financial markets. How do we build this market for advice? How do we integrate robo-advisory with human distribution? How do we understand households use of such advice? What makes households follow advice?
Understanding risk preferences
While a lot of our energy so far has been consumed by understand the supply-side problems in India in the form of distribution, or weak regulation, a crucial component in making this market work is the preferences of households themselves. What is the level of risk aversion among Indian households? How does this vary with income, education, location, employment? How does this then determine financial choices? Does this evolve over time? A detailed study on risk preferences of Indian households will go a long way in understanding the determinants of choices made by households.
Dissecting financial literacy
If households have to engage with financial products, then they must be able to understand what kind of a product matches their need, and what a product truly offers. This requires a basic understanding of finance, and the ability to engage with a financial intermediary. An important area of research, therefore, is to understand what financial literacy means, and what aspect of financial literacy is likely to get us the most gains? Can we isolate a few factors that will give us disproportionate gains in how households understand financial products?

Household finance in India is a field where the literature is just beginning to emerge. There is one strand of literature which treats micro data in India as a laboratory where questions of interest in the US can be addressed. However, it is far more interesting to have roots in local knowledge, to identify the important questions relevant to local conditions and constraints, and to craft credible research designs that can feed into important questions in India. This would involve being at the interplay between new datasets, innovations in the industry, and the policy process.

### References

Ananth, B., G. Chen, and S. Rasmussen (2012). The pursuit of complete financial inclusion: The KGFS model in India. In Access to Finance Forum, Reports by CGAP and its Partners, vol. 4.

Burgess, R., and R. Pande (2003). Do rural banks matter? Evidence from the Indian social banking experiment. Evidence from the Indian Social Banking Experiment (August 2003)., Vol (2003).

Anagol, S., V. Balasubramaniam and T. Ramadorai (2015), Endowment Effects in the Field: Evidence from India's IPO Lotteries, Available at SSRN.

Anagol, S. and H. Kim (2012), The Impact of Shrouded Fees: Evidence from a Natural Experiment in the Indian Mutual Funds Market, The American Economic Review, 102(1).

Bose Committee Report (2015), Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products, Ministry of Finance, Government of India.

Campbell, J., B. Ranish and T. Ramadorai, (2013), Getting better: Learning to invest in an emerging stock market, Available at SSRN.

Cole, S., X. Gine, J. Tobacman, P. Topalova, R. Townsend, and J. Vickery (2013). Barriers to household risk management: Evidence from India, American Economic Journal: Applied Economics 5, no. 1 (2013): 104-135.

Gaurav, S., S. Cole, and J. Tobacman (2011). Marketing complex financial products in emerging markets: Evidence from rainfall insurance in India, Journal of Marketing Research 48, no. SPL (2011): S150-S162.

Halan, M., R. Sane and S. Thomas (2014), The case of the missing billions: Estimating losses to customers due to mis-sold life insurance policies, Journal of Economic Policy Reform, October 2014.

Halan, M., and R. Sane (2016). Misled and mis-sold: Financial misbehaviour in retail banks? NSE-IFF Working paper.

Hastings J., B. Madrian, and W. Skimmyhorn (2012). Financial literacy, financial education and economic outcomes. No. w18412. National Bureau of Economic Research.

Mowl, A. and C. Boudot (2014). Barriers to Basic Banking: Results from an Audit Study in South India, NSE Working Paper Series No. WP-2014-1, NSE-IFMR Financial Inclusion Research Initiative 2014-2015.

Sane, R. and S. Thomas (2015), In search of inclusion: informal sector participation in a voluntary, defined contribution pension system, Journal of Development Studies.

Sane, R. and S. Thomas (2016), From participation to repurchase: Low income households and micro-insurance, IGIDR Working paper, June 2016.

Swarup Committee Report (2009), Financial Well-Being: Report of the Committee on Investor Awareness and Protection, Ministry of Finance, Government of India.

The author is an academic at the Indian Statistical Institute, Delhi Centre. I thank Monika Halan, Anjali Sharma and Susan Thomas for useful discussions.

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