Invoice financing in India: TReDS and way forward

by Sudipto Banerjee and Vishal Trehan.

Introduction

Medium, small and micro enterprises (MSMEs) operate on tight margins and need immediate settlement of invoices to avoid shortage of working capital. However, due to the poor bargaining capacity of MSMEs, their working capital often remains blocked in receivables as they work on an unfavourable credit cycle for goods and services supplied to corporate buyers. This problem is exacerbated due to the existence of a huge funding gap for MSMEs. In order to bridge the gap between invoice date and its due date, invoice discounting emerged as a financing solution for entities which are unable to access funding options such as short term credit and working capital loans. Under invoice discounting, the seller, instead of waiting for the payment to be made by the buyer, gets a certain percentage of the invoice amount from the financier in advance. The seller pays a fee to the financier for this discounting service. Once the invoice amount is received by the seller from the buyer, it repays the amount to the financier.

However, adoption of invoice discounting as a financing mechanism in India has not been as expected. This may be due to several reasons. First, the bargaining capacity is skewed in favour of corporate buyers who express reservations while accepting assignments of receivables made in favour of financiers. Second, it is difficult for financiers to establish the credit rating of MSMEs due to information asymmetry. This, coupled with the absence of pledgable collaterals increases the credit exposure of a financier. Third, the discounting landscape is still dominated by banks and there are very few specialised discounting entities. Finally, there is a lack of awareness among MSMEs about discounting services, especially in non-urban locations. For example, even though many MSMEs are exporters, they lack information about export factoring.


In 2014, the RBI observed that there is a need for institutional setup to boost discounting in India and for this purpose conceptualised an electronic exchange for invoice discounting known as trade receivable electronic discounting system or TReDS. This post looks at the TReDS platform critically in order to assess whether this fintech solution has been able to address specific issues related to invoice discounting in India. Further, we explore the developments around invoice discounting in the context of new technologies and examine whether their adoption holds any merit. It must be noted that the invoice discounting problem space is quite broad and TReDS, a technology based solution, must be seen as a solution for specific problems in the invoice discounting space in India.

Specifically, TReDS seeks to address the problem of information asymmetry and the consequent high rates offered by financiers. Also, it is envisaged to reduce the time taken for sellers to receive payments. TReDS, however, was not conceptualised to address other persistent issues related to invoice financing. For example, although TReDS operates on the concept of 'no rescourse to seller', it is not a solution to the problems arising out of the bargaining power of buyers.

A digital platform to boost invoice discounting

In 2009, SIDBI, in collaboration with NSE set up the first e-discounting platform for MSME receivables. This was based on the lines of the Mexican NAFIN model. However, this was a closed single financier model and therefore, had limited scale of operation. To overcome these limitations, in 2014, RBI released a concept paper to set up a full fledged electronic exchange for invoice discounting. This was followed by TReDS is essentially an online electronic institutional mechanism for facilitating the financing of trade receivables of MSMEs through multiple financiers. The platform enables discounting of invoices of MSME sellers against large corporates including government departments and PSUs, through an auction mechanism, to ensure prompt realization of trade receivables at competitive market rates.

• In the TReDS ecosystem, sellers, buyers and financiers can come on board by executing a one time agreement with the platform. This reduces the documentation cost for sellers who have to execute a separate agreement everytime there is a discounting transaction with a different financier.
  
• After executing the agreement, once the seller provides goods or services to the buyer and after acceptance by the buyer, the invoice is uploaded on the platform. This can be uploaded either by a buyer or a seller. Once the invoice is accepted by the buyer, it is converted into a factoring unit, a nomenclature used for invoices on the platform. Subsequently, an electronic auction involving bidding for the factoring unit takes place on the platform.
• Once a bid is accepted by the seller, the amount is credited to the account of the seller either on T+1 or T+2 basis depending on the cut-off time. This financier's account is auto-debited through the National Automated Clearing House (NACH) mandate. Instructions are sent electronically by the platform to the parties. On the due date of the invoice, the bank account of the buyer is auto debited and the amount is credited to the account of the financier.

As mentioned previously, the TReDS platform aims to address certain specific aspects of MSME financing. The current invoice financing system is riddled with an asymmetric flow of credit information. Financiers are not always aware of the financial condition of MSME suppliers due to limited publicly available information. Due to this, screening costs incurred by a financier go up for discounting an invoice of a MSME supplier. TReDS ensures easier access to invoice discounting at better rates for MSME suppliers due to the following reasons:

• Financing on the TReDS platform is done on the credit rating of the corporate buyers, hence, financiers need to define the credit limit of buyers and not sellers. This reduces the due diligence cost for financiers and in turn lowers the cost of discounting for sellers.
• TReDS operates on the model of without recourse to the seller which means that the financier can recover the invoice amount only from the buyer.
• Outside TReDS, MSME sellers negotiate with individual banks and NBFCs who may not offer them competitive rates for the reasons discussed above. The average interest rate on working capital loans is 12% as compared to 8-10% on TReDS. TReDS allows multiple financiers to participate and bid for invoices - this is expected to provide better rates to MSME sellers. As described previously, the entire transaction happens digitally on the platform in an efficient and transparent manner.

Establishing the genuineness of an invoice is another challenge that TReDS addresses. Once the seller provides goods or services to the buyer and they are accepted, the invoice is uploaded on the platform. The bidding by financiers start only after the uploaded invoice is accepted by the buyer. However, the issue of double discounting of invoices was not addressed in the original implementation of TReDS. This was addressed through a blockchain implementation recently.

Key issues

The most critical problem in the invoice financing space in India, and consequently in the TReDS setup, is related to the obligation on buyers to repay on time. TReDS too follows the requirement of the Micro, Small And Meduim Enterprises Development Act, 2006 (MSMED Act, 2006) which imposes an obligation on buyers to settle the invoice amount within 45 days. Hence, in the TReDS ecosystem, the buyer has to pay the factored invoice amount to the financier within 45 days from the date of acceptance of bid by the seller. This requirement of adhering to time bound payment, which is otherwise mostly flouted outside TReDS, can cause reluctance on the part of buyeres to sign up. Presently, MSME suppliers facing competition from other players are inclined to accept higher volumes of trade credit on less favourable collection terms.

Interactions with practitioners in the MSME financing segment revealed that at times, sellers also avoid disclosing their MSME status so that the buyer is not deterred by the applicability of MSMED Act in case of delayed payments. Therefore, it is not surprising that buyers have even instructed their vendors not to sign up on the electronic platform to avoid the time bound commitment to pay.

Other related challenges with TReDS

While TReDS is a technology based solution to provide an institutional platform to boost MSME financing, its performance needs to be evaluated against the market's response. The market usually adopts a particular solution for two reasons - it can either be a business need or a legal obligation. Considering that the TReDS platform came about as a result of the practice of delayed payments by buyers, it is important that we examine the incentives for buyers to come on board.

1. Restriction on raising disputes: It must be noted that presently TReDS is an optional system. Assuming there is a corporate buyer X dealing with several vendors, under TReDS, X has to execute an agreement where it accepts the invoice of the seller (its vendors) and only after such acceptance, an invoice is made available for auction on the exchange. The TReDS Guidelines specifically require that X cannot dispute the goods or services received from the seller at a later stage. This is a major disincentive for buyers. Outside TReDS, X usually does not give acceptance to suppliers but merely records the event that it has received supplies - thereby keeping an option to dispute them in the event of any deficiency.
2. No recourse to seller: In the non-TReDS setup, if X defaults in paying the financier on the due date, the seller becomes a debtor vis-&agrave-vis the financier for recovery purpose. However, as discussed above, on the TReDS platform discounting is done without recourse to the seller. This means that if X fails to pay the invoice amount on the due date, the financier would have no recourse to the seller. Instead, the financier will have to pursue the buyer. While this mechanism may reduce the financier's risk, it may not attract buyers as they would now have to deal with an institutional lender who replaces the MSMEs.
3. Enhanced transparency: In case of default or any delay in payment by the buyer to the financier on TReDS, the delay/default gets duly recorded and can feed into the credit rating of the buyer. Outside TReDS, instances of such delay or default are not recorded, unless the MSME seller chooses to pursue action under MSMED Act at the cost of its future business relationship with the buyer. Therefore, the decision of a buyer to join TReDS would most likely depend on a cost-benefit analysis of aspects such as reduced flexibility in cash flow management, more transparency, etc.
4. Existing arrangements: Experts in the MSME financing area have pointed out during interactions that many big corporate houses have their own discounting business and their suppliers/vendors are required to avail discounting services from their group entities. For instance, Reliance Capital, Mahindra Finance, Tata Capital, Bajaj Finance, Aditya Birla Capital, etc are full fledged NBFCs and have dedicated invoice discounting divisions. Companies not having such an in-house discounting facility usually have pre-existing arrangements with banks or NBFCs. Moreover, these big houses usually consolidate their vendor payments into select groups not falling within the category of MSME who in turn buy products from MSMEs. This may be another reason for big houses to not come on board TReDS.
5. Cost of integration: Another barrier, especially from the buying corporates, is their reluctance to invest in the cost of integrating into a system like TReDS. Since the buyer bears the costs but the benefits accrue only to vendors, this
   may prove to be a disincentive for the buyers.
6. Poor awareness: Lastly, the level of awareness about any new solution determines its success. Based on inputs from several stakeholders such as discounting entities and banks, the overall level of awareness about TReDS does not appear to be encouraging. Further, in smaller towns and semi urban setups, banks are the predominant option available to suppliers for their financing needs. These sellers do not easily switch banks with whom they share an established relationship, unless the buyer takes the initiative to migrate their dealings onto TReDS.

Addressing the issues

In order to ensure that the TReDS platform achieves its objectives, broader issues related to invoice financing in India as well as TReDS specific concerns need to be addressed. Extending the timeline of 45 days for settlement of invoice, which presently could be the prime reason for buyers not coming onto the TReDS platform, may be considered. To begin with, the platform should be enabled to give an extension to buyers on a case by case basis. While balancing the conflicting interests of suppliers, buyers and vendors is a challenging task, a middle path can be arrived at by ensuring constant interactions between the regulator and the stakeholders, especially the buyers. Further, it is essential that RBI invests resources to increase the overall level of awareness about TReDS. As discussed previously, the focus of such an awareness programme should be smaller towns and semi-urban setups.

Alternatively, a light-touch approach to regulating the behavior of large buyers could involve doing away with the 45 day payment period for TReDS so as to incentivise big buyers to get onto the TReDS platform. Instead, buyers may be asked to disclose their payment practices. Such reporting is mandatory in the UK where firms are required to disclose payment practices as per the Small Business, Enterprise and Employment Act, 2015. Removing the time-line of 45 days and mandating disclosure of payment practices would require amendment of the MSMED Act, 2006. The disclosures, which can be made public on TReDS, should also form a part of the notes to accounts of financial statements of such firms so that they can be cross verified by statutory auditors. This would require amendment to Schedule III of the Companies Act, 2013.

Further, there could be a mix of other regulatory tools like:

• A code similar to the Prompt Payment Code in UK can be created and large buyers may be encouraged to sign on to this code. Such a voluntary code can in turn set a maximum payment term.
• A system for blacklisting companies which violate payment terms repeatedly may also be created based on the payment practices data.
• The role of MSME associations is important in this context to ensure that big buyers do not abuse market power. As is generally the case, a single MSME will be reluctant to file a complaint against a buyer for fear of losing business as well as the costs involved. Instead, MSME associations can give MSMEs the requisite support and can help MSMEs collectively protest against a buyer to enforce a change in behaviour.

Additional measures for boosting TReDS

RBI may take additional measures after taking stock of bottlenecks currently faced by the TReDS platform to ensure that the platform achieves its intended objectives. These include:

1. Presently, only banks and NBFCs are allowed to participate on TReDS. These entities lend as per the minimum credit lending rate. TReDS Guidelines do not allow any other entity to participate on this platform as a financier. Considering that the objective of TReDS is to boost MSME financing, RBI may consider lifting this restriction after doing a cost-benefit analysis. More participants such as urban cooperative banks, regional rural banks, high net worth individuals (HNIs), mutual funds, pension funds, etc. may be allowed to ensure the best rates for MSME suppliers. Such participation is allowed in other jurisdictions. For example, UK based MarketInvoice connects businesses with investors, including HNIs through its peer-to-peer invoice finance platform.
2. On the supplier side, the option of allowing non-MSME entities can also be explored. For example, a corporate buyer on board TReDS presently would have to maintain an additional payment mechanism for non-MSME segment. This leads to operational inefficiencies for the buyer. Allowing both segments on TReDS may ease their way of doing business.
3. Several MSMEs lack reliable information systems which can generate invoice suitable for discounting. To address this problem, in the Union Budget 2018-19, it was declared that TReDS would be linked to the Goods and Service Tax Network (GSTN). Further, as discussed previously in the post, financing in the TReDS environment is done on the credit worthiness of buyers on 'without recourse to seller' basis. This can potentially create disincentives for buyers to come onboard. If financiers are allowed to access the transactional data of MSME sellers available on GSTN, subject to certain safeguards like privacy of data, this can reduce their information asymmetry in terms of assessing the credit history of sellers. In other words, this measure can enable financiers to discount invoices based on the credit worthiness of sellers.

Technology solutions to address challenges

Some technological solutions are also being explored to address specific challenges with TReDS. The three licensed TReDS exchanges recently got together with MonetaGo, a US based startup, to implement a blockchain based solution for a specific problem - the problem of double invoicing and associated fraud. This permissioned blockchain solution, with each of the exchanges acting as a node, went live recently. This solution has enabled the three exchanges to work together to eliminate instances of double discounting while protecting confidential information of their clients. The system generates a hash which is used by the exchanges for validating whether an invoice has already been discounted or not.

In other parts of the world too, blockchain is being considered to develop end-to-end solutions for invoice financing. Several early implementations already exist - examples being Populous in the UK and the Hive Project in Slovenia. More specifically, blockchain is being used to:

• Ascertain the legitimacy of an invoice
• Find out whether the invoice has already been discounted
• Make available immutable contract information securely to all stakeholders, thus ensuring transparency
• Create incentives for quicker payments
• Reduce costs related to the invoice financing process

Need for a cautious approach

In view of the decision by the three exchanges to move the fraud-detection module of the TReDS platform onto a blockchain, going forward, authorities and other stakeholders must follow a cautious approach when considering a blockchain solution for other modules of the invoice discounting process of TReDS. A blockchain based solution is envisaged to reduce costs associated with invoice financing and also incentivise quicker payments by bringing in transparency of transactions through a distributed immutable ledger. However, certain considerations need to be made to come up with the most appropriate design approach in the Indian context:

1. Will a blockchain solution incentivise buyers? Considering the reluctance of buyers to come onboard TReDS due to
   the lack of a dispute resolution mechanism, it is critical for any future blockchain implementation to tackle this issue. Buyers may want a transparent mechanism on the blockchain which allows them to flag the quality of goods/services sold to them even after accepting the invoice.
2. Is a blockchain the best design choice?
   Various design choices, including centralised and distributed databases, must be considered and a cost benefit analysis must be done to choose the most efficient solution.
3. Will the solution help achieve RBI's objectives?
   Depending on RBI's objectives and factors such as trust among stakeholders, a permissioned or permissionless blockchain solution might be more suitable in case a blockchain solution is found to be the right choice.
4. Issues of security, scalability and governance: Blockchain solutions with public facing data and handling a large number of transactions have been known to struggle with issues of throughput capacity and security. Further, complex questions such as who controls the blockchain, who are the nodes in case of a permissioned blockchain with multiple stakeholders and what is the consensus mechanism need to be answered.
5. How will the solution respond to a complex and dynamic environment?: A blockchain based 'smart contract' solution for invoice financing should be able to quickly adapt to complex and fast-changing real world environments - for example, changes in the regulatory framework.

It is important that a blockchain solution is adopted only if it is addressing persistent challenges in the Indian context. Characteristics/features of the technology itself pose another set of questions when considering the solutions. Thus, a cost-benefit analysis is of paramount importance before deciding the design of the solution.

Conclusion

Several measures have been taken over the past few years to boost invoice financing in India. Although TReDS is a good initiative, we must carefully evaluate its effectivesness to address the lacunae in the system. To this end, we have examined the existing design and performance of TReDS after considering the market's response and expectations of stakeholders. Primarily, a lack of incetives for buyers is holding up widespread adoption of TReDS. This is due to structural issues in the invoice discounting space as well as challenges with the TReDS platform. This classification of challenges is necessary since merely fixing the technology platform may not address the underlying distortions. Thus, both types of challenges - structural ones such as the bargaining power of buyers and TReDS related challenges like the absence of a dispute resolution mechanism within TReDS - need to be addressed to ensure TReDS' success.

Further, a cautious approach needs to be adopted when considering novel technology solutions for such challenges. In sum, this multi-layered problem needs a concerted effort from the authorities to uncover issues at the ground level and come up with the appropriate policy and technical solutions.

References

Department of Economic Affairs, Industry and Infrastructure, Economic Survey 2017-18 Volume 2, 127-128.

Mohmad, K. M. Factoring Services in India: A Study, 2015.

Reserve Bank of India, Concept Paper - Trade Receivables and Credit Exchange for Financing of Micro, Small and Medium Enterprises, 2014.

Dylan Yaga et al, Blockchain technology overview, 2018.


The authors are researchers at the National Institute of Public Finance and Policy. The authors would like to thank Radhika Pandey and Anirudh Burman for useful discussions.

The editor for this article was Anjali Sharma.

Concerns about Atal Pension Yojana

by Renuka Sane.

In the recent budget, the Finance Minister announced the Atal Pension Yojana, which promises a fixed pension of at least Rs.1,000 at age 60 if subscribers contribute pre-defined amounts over their working life. The APY suffers from five problems.

1. Clarity of objective. The NPS-Swavalamban (NPS-S) has been the flagship pension scheme for the informal sector since 2010. While it has taken root over the last few years, problems in the design and process of the scheme persist. The APY seems to be motivated by these concerns. The scheme document says: `... coverage under Swavalamban Scheme is inadequate mainly due to lack of clarity of pension benefits at the age after 60. The Finance Minister has, therefore, announced a new initiative called Atal Pension Yojana (APY) in his Budget Speech for 2015-16'. Clarity of pension benefits could be interpreted as clarity of process for receipt of benefits, or certainty about the amount of benefit. The exact interpretation has not been made clear. It seems that the intent of the government is to migrate the entire existing NPS-S to the APY [See Page 7 of the APY FAQs]. It is not clear that this is the right approach. A careful examination of the lessons obtained from NPS-S over the last four years (e.g. Sane and Thomas, 2015) would have helped design a better response. Perhaps there was a role for co-contribution separately from the pension guarantee.

2. Design of the procedure. There is considerable confusion on how the APY is actually going to work. Initially, the APY was to be sold through the same aggregators that distribute the (NPS-S). New documentation indicates that it is actually only open to bank account holders. All the existing NPS-S customers are to be migrated to the APY with an option to opt-out. Does this place the responsibility of opening bank accounts for NPS-S customers on the aggregators? What happens to those who wish to continue with the NPS-Lite i.e. use the NPS without the co-contributions? In that case, the PFRDA ought to define well-defined standards of skill and care that aggregators will be expected to exercise towards a customer as invariably the aggregator will end up playing the role of an advisor when making a decision on whether to opt-out of the APY, or continue only the APY or continue the APY along with NPS-Lite.

The scheme levies penalties on those who are not able to maintain the required balance in the savings bank account for contribution on the specified date and close bank accounts if contributions are not paid for 24 months. However, we know from the NPS-S experience that informal sector workers often do not have liquidity, are not able to contribute on time, but do come back over subsequent periods. This design of the APY will invariably exclude those who cannot maintain a balance in their savings bank accounts or make regular contributions, defeating the purpose of providing a formal sector savings mechanism.

3. Price of the guarantee. Apparently innocent guarantees can prove to be disastrously costly when viewed in their entirety (e.g. Shah, 2003). The APY seems to be motivated by the desire of the government to ensure that on contributing continuously, a member gets at least a pension of Rs.1,000. While not explicitly specified, the APY seems like a minimum return guarantee which will ensure that accumulated savings at retirement do not fall below a certain value. There are different kinds of guarantees, and several ways to design minimum return guarantees. For example, an absolute rate of return guarantee promises a pre-specified rate of return, while a relative rate of return guarantee promises a return close to the average of all funds. The motivation for the choice of this particular design, and the calculations that influenced the choice have not been articulated. Under the APY the subscriber may actually be getting a sub optimal return. This is not surprising, as all guarantees come at a cost (Pennacchi, 1999). However, policy makers need to show the application of mind: the class of guarantees which was evaluated, and the logic that led up to this choice. The contributions under APY are to be invested as per the investment guidelines prescribed by Ministry of Finance, Government of India. The investment guidelines, and how they would finance the guarantee of the APY are not yet clear.

4. Safeguards against arbitrary increases. Almost all pension guarantees in the world have turned into fiscal problems. Even if a guarantee is fiscally sound at the outset, modifications to the program design later on render it bankrupt. Governments are tempted to increase benefits prior to an election. Apparently innocuous changes are announced, which add up to many percentage points of GDP. Any guarantee program requires an elaborate array of safeguards to protect against reckless actions in the future. The APY features no safeguards. It does not require governments to show actuarial calculations before any changes to the design are introduced. An example of a defined benefit guaranteed return plan running into funding difficulties is the Employees Pension Scheme (EPS). Estimates suggest that the EPS is facing a shortfall of Rs.54,000 crore, and several changes in scheme design have now been put in place owing to these funding difficulties.

5. Improper process. Indian finance has taken a big step forward by committing to the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code. The procedural requirements in the Handbook, for framing regulations include a statement of objectives and a cost benefit analysis of each of the provisions. Many of the mistakes of the APY could have been avoided by the use of this process. It is not too late to apply this process to APY, even now.

References

Pennacchi, G. (1999), The value of guarantees on pension fund returns, The Journal of Risk and Insurance , 66(2), pp: 219-237.

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

Shah, A (2003), Investment risk in the Indian pension sector and role for pension guarantees, Economic and Political Weekly, 38(8).

A dramatic cost reduction for KYC using the e-KYC API of UIDAI

by Suyash Rai, Smriti Sharma, Sanhita Sapatnekar.

The problem

On 2001-09-11, Mohammad Atta hijacked American Airlines Flight 11 and flew it into the North Tower of the World Trade Centre. Tracing flows of money led to the observation that a high ranking official within Pakistan's Inter-Services Intelligence (ISI) had allegedly ensured more than USD 100,000 was wired to Mohammad Atta, before the attack took place. Law enforcement authorities became quite keen to observe and block the `financing of terror'.

The Financial Action Task Force (FATF) develops and promotes policies that hinder money laundering, financing terrorism and financing weapons of mass destruction. One element of this requires financial institutions of member countries to implement `Customer Due Diligence' (CDD) for a variety of financial activities and circumstances. India is a member of FATF and Indian regulators are obliged to apply CDD. Regulators in India have applied CDD through excessive forms of `Know Your Customer' (KYC) requirements, which go well beyond the principles-based risk-sensitive requirements of CDD. As a result, financial firms in India face increased costs.

When an Indian financial service provider deals with a low value customer, the cost of performing the KYC that's required is often a substantial one when compared with the lifetime NPV of the customer. This has hampered financial inclusion by reducing the profitability of small value customers in the eyes of financial firms.

In 1999, Project OASIS (Old Age Social & Income Security) was established by the Ministry of Social Justice and Empowerment to make recommendations on how to develop old age income security. One of the key insights of Project OASIS was the importance of modern computer technology for the objective of serving small value customers. Paper- and human-intensive processes can even be viable for the rich, but when dealing with poor people, the only way to make ends meet is to push to the frontiers of technology.

A new attack upon the KYC problem

The Unique Identification Authority of India (UIDAI) has developed a novel technology that cuts the cost of opening an account by approximately 80%. The steps of this process are as follows:

1. First, the customer has to have already enrolled in Aadhaar once. This involves supplying the name, identification, address details, and biometric data including the photograph. As there are many Aadhaar applications springing up in India, many individuals have ample incentive to undertake this cost of enrollment, once. Recent data shows that 670 million people in India have enrolled.
2. Now let's focus on the account-opening process at a financial firm. The customer shows up with his Aadhaar number.
3. The staff-person at the financial firm engages with the customer and takes the Aadhaar account number and captures fingerprints using a device.
4. Aadhaar has provided an applications programming interface (API) through which the software at the financial firm now reaches into the Aadhaar database, presents (encrypted) credentials of a Aadhaar number and matching fingerprints, and requests a packet of information.
5. This information is used to populate the form for the account-opening process. E.g. the photograph is brought from the Aadhaar database and placed into the account opening form. The entire process -- from fingerprint to completed form -- takes roughly 15 seconds.

e-KYC eliminates human effort in account opening, and allows residents to present their KYC information electronically and instantaneously, without needing any physical form of identity or address proof. e-KYC eliminates the movement and storage of verification papers, and therefore costs of document management. Error-free data is obtained from the Aadhaar database, at a much lower cost when compared with the costs of typing in and removing the errors in human-created data. e-KYC is a game changer when it comes to opening accounts for poor people.

An example

Invest India Micro Pension Services (IIMPS) enables low income informal sector workers to accumulate micro-savings for their old age. It has faced KYC challenges in the past, and is an early adopter of e-KYC. IIMPS's target population, i.e. the informal sector poor, cannot gain access to formal financial products as they have insufficient identity documentation (due to factors such as migration), or a complete lack thereof. As a result of this, and due to differences in KYC compliance across regulators, a host of interested low income workers are unable to join the integrated micro-pension program. This is only the first half of the problem. Lengthy KYC application and verification procedures cause significant cost and time overhead expenses for IIMPS while processing each micro-pension application. e-KYC has resolved both of these issues.

Watch a demo

See the video on the nipfpmf channel on youtube.

Making it a reality

In the past, there has been doubts regarding the future of UIDAI's Aadhaar project. However, the BJP government has recently reaffirmed its interest in continuing with it. e-KYC is a valid document for all financial services, under the Prevention of Money Laundering Act Rules. e-KYC has also been accepted as valid proof of identification and address by five regulators in the financial sector, namely the Reserve Bank of India (RBI) ; the Securities and Exchange Board of India (SEBI) ; the Pension Fund Regulatory and Development Authority (PFRDA) ; the Insurance Regulatory and Development Authority (IRDA) ; and the Forward Markets Commission . It is also compliant with the Information Technology Act, 2000. This means the encryption and digital signatures ensure both end-points of the data transfer are secure, making e-KYC legally equivalent to KYC paper documents. e-KYC is up and running. However, most financial firms do not (at present) utilise it. They need to modify their software systems in order to utilise the API. As only 670 million people are enrolled in Aadhaar, financial firms have to have the ability to do the old-style KYC also. In the future, there could be situations where the entire process capability for conventional KYC is removed, which would further reduce costs.

Regulatory strategy for savings/investment schemes, that would address ponzi schemes

by Suyash Rai and Smriti Parsheera

The first task in dealing with ponzi schemes is correctly defining the scope of financial regulation. Once a firm is classified as a financial service provider, the appropriate regulator must choose a regulatory strategy for it. Assuming SEBI had clear jurisdiction with Sahara or MMM, what would SEBI do?

Safety and soundness regulation (also called micro-prudential regulation) is an expensive form of regulation, which includes requirements relating to maintenance of capital, investment restrictions, corporate governance, risk management systems, etc. This type of regulation can not apply equally to every financial institution. For example, the regulator should be able to distinguish between small member-controlled chit funds and larger chit funds.

Differences also need to be drawn based on the nature of the activity being carried out. Micro-prudential regulation should be less stringent for investment schemes as compared to deposit-takers, given the difference in the nature of promises being made to consumers. However, at the very least, the scheme would require authorisation from the regulator. In the MMM India example, had the scheme sought such approval, its promoters would have to satisfy basic fit and proper person requirements. Given that the scheme has been floated by Sergey Mavrodi, a convicted fraudster and the man behind Russia's largest Ponzi scheme, it is likely that the scheme would have failed on this count.

This points to the need for a sophisticated approach to ensure optimal regulation. The law should allow the regulators to apply safety and soundness regulation wherever required, but the decision can't be left to the regulators unconditionally. The law must provide some guidance to them, to make them accountable. What could be the form of this guidance?

Consider the following examples:

• A bank with Rs. 10,000 crores of deposits from 1 crore depositors.
  
• A local chit fund with Rs. 10,000 from 20 members.
  
• A chit fund with Rs. 1000 crores from 1 crore members.
  
• A hedge fund investing Rs. 1,000 crores, from 50 investors.
  
• A mutual fund investing 10,000 crores, from 1 crore investors.
  

Where should safety and soundness regulation apply, and what should be the intensity of the regulation? A closer look reveals a few distinctions on four dimensions.

The bank and the large chit fund are more opaque than the others - most of the important information about their asset quality is not visible. That is why we are often taken aback when they fail. In small chit funds, people have reasonable visibility, since the money is with one of the members and is distributed regularly. Hedge funds and mutual funds are also quite easy to monitor, as long as they report fairly, because they invest in securities that visible in the market on a real time basis.

Bank and the chit funds make promises that are inherently more difficult to fulfill - they must return money, irrespective of their financial position. Banks more so, because the deposits are callable at par. Hedge funds and mutual funds invest on behalf of investors, with no guaranteed rate of return and so the market risk stays with the investors. Institutions making promises inherently more difficult to fulfill are at a greater risk of failing to keep the promises.

There is a difference in the influence the consumers can wield over the institution. In a small chit fund, members have significant influence over each other. In game theory terms, they are in a repeated game over a long horizon - small amounts are saved over short periods, and this is repeated. When a few people become managers of funds for a large number of people, the moral hazard problem increases exponentially, and the consumers' ability to influence the institution drops. Similar difference can be seen in the hedge fund (small number of high value investors), and the mutual fund (large number of small value investors).

The institutions differ in terms of consequences of their failure. If a bank or a chit fund fails, many poor and middle class people lose their savings and many suffer significant hardships. We are seeing this in Saradha's case.

Each of these four distinctions is relevant for deciding where safety and soundness regulation should apply. They can be stated in terms of principles, but do not translate into a set of ex-ante rules in terms of institution-types. If the law states them in terms of rules, it may be gamed. The principles, therefore, must be in the law.

Section 151(1) of the Indian Financial Code provides four principles-based tests, based on the four distinctions discussed above, that will help the regulators decide where and to what extent safety and soundness regulation should apply. The regulators will use a combination of these principles to take the decision. For example, it is not enough that the promise is inherently more difficult to fulfill, the institution should score high on some other tests as well. From the five examples listed earlier, the bank and the large chit fund will be intensely regulated for safety and soundness, and the mutual fund would attract some regulation to ensure that it is acting prudently and reporting fairly. The small chit fund and the hedge fund may be largely exempt.

Handling failure

Even among the licensed and regulated deposit-taking institutions, some will become weak. In such situations, there are ways of stemming the decline, and if the institution fails, minimising the loss to depositors. Dealing with failure requires a sound resolution and deposit insurance system. Deposit insurance covers deposits, upto a limit, against the risk of failure of the institution.

At present, banks in India are covered by a deposit insurance system, which, as demonstrated by the experience of many urban cooperative banks, often takes a long time to settle claims. Bank-like institutions, such as deposit-taking NBFCs, are not covered by deposit insurance. Countries like US and Canada have elaborate systems of resolution, which may include sale of the firm, management through a bridge institution, and temporary public ownership. The agencies responsible for resolution are also empowered to take corrective action if a firm's soundness declines. In India, there is no system for resolving failing firms, and no structured framework for corrective action.

Part VII of the IFC provides for a resolution corporation, which will provide deposit insurance to certain institutions, take corrective actions on firms becoming weak and resolve institutions before they become insolvent, by arranging a sale of the firm, managing it through a bridge institution, or facilitating temporary public ownership. Section 260 enables extension of deposit insurance to institutions taking deposits. The regulators, in consultation with the resolution corporation, will decide which institutions will be covered by deposit insurance. This decision will be taken based on tests like the ones proposed for deciding where safety and soundness regulation will apply.

Enhanced consumer protection

The operators of the MMM scheme claim to make full disclosures to their members about the uncertainty of returns and the risk to their funds. But is mere disclosure sufficient to absolve Ponzi scheme operators from all liability? Certainly not. While disclosure and transparency requirements are integral components of an effective consumer protection regime, research shows that when faced with complex financial decisions, consumers often suffer from cognitive biases which can result in sub-optimal decision making.

It is for this reason that IFC contains additional protections when retail consumers are advised on financial products. This is in the form of suitability assessment requirements that compel the managers and distributors of financial products to assess the relevant personal circumstances of individual scheme members and the suitability of the product for their purposes before advising them to join such schemes.

Correctly defining the scope of financial regulation so as to block ponzi schemes

by Smriti Parsheera and Suyash Rai.

Attack of the ponzi schemes

The Saradha Group has gained notoriety in recent weeks with outstanding public deposits reportedly exceeding Rs.200 billion. There was anger and panic. The state government has stepped in with partial redress.

As we watch this saga unfold, there may be another crisis waiting to happen in the form of a pyramid scheme offered by `Mavrodi Mondial Moneybox (MMM)' that is taking rural India by storm. MMM claims to be a `social financial network' in which members voluntarily share money with each other by buying and selling MAVROS - a currency-like unit devised by the operators of the scheme. MMM claims to generate returns of over 40% per month, although the returns are not guaranteed. It may be a ponzi scheme: one where money collected from new investors is used to pay returns to old investors. The cycle will continue till inflows into the scheme exceed outflows.

Saradha and MMM are not isolated examples. Other recent schemes have involved promises of unrealistic returns from investments in goats, pigs, emu, teak wood and potatoes.

The history of savings and investments in India is replete with tragedies where financial firms fail to return deposits or investments. This is particularly problematic in a country where 70% of the people earn under 2 dollars a day and hence have small amounts of money saved up. If savings are not safe, the central objective of regulation - consumer protection - is not met. What we need is for institutions that take deposits or run investment schemes to operate in a safe and sound manner, within the bounds of financial regulation.

Under-regulation

Under the present system there are many institutions that offer deposit or investment services without any form of approval or regulation. Under a fragmented regulatory system, hazy lines of work have been drawn between financial regulators, the Central Government and State Governments. This has led to the problem of under policing - anything that does not fall squarely within the lines tends to pass unnoticed from under the radar of regulation. Saradha presents a good example - its activities could be argued to fall under any of the following categories: running a collective investment scheme (regulated by SEBI); running a chit fund (regulated by the state government); a private company taking deposits for its business (regulated by the Registrar of Companies); and taking public deposits as a non-banking financial company (regulated by RBI). The Saradha Group chose to seek permission from none of these.

There is also inconsistency in the manner and extent of regulation of financial institutions performing similar activities. For instance, 265 non-banking financial companies and 18 housing finance companies are allowed to take public deposits, but they don't enjoy the same deposit insurance protection that is available to banks. If the main rationale for deposit insurance is to protect depositors from the risk of a financial institution becoming unable to make good on its promise to refund public deposits, should the same logic not apply to all deposit takers?

Chit funds, which are governed by State governments, also suffer from the problem of inconsistent treatment. Differences in enforcement levels across States have resulted in some States becoming more prone to ponzi schemes. In addition, most this sector may be operating in the form of unregistered chit funds: it is estimated that registered chit funds have collected Rs.300 billion worth of deposits while the collection of unregistered funds is much higher at Rs.30 trillion.

The regulation of collective investment schemes that come under SEBI's scanner has also left much to be desired. This is largely on account of the restrictive mandate. Section 11AA of the SEBI Act defines "collective investment schemes" in terms of principles to identify such schemes, but it contains exemptions for institutions such as chit funds, nidhis and cooperative societies. Pointing to the huge investment grey market that plagues the financial sector, the SEBI chairman U. K. Sinha observed that the loopholes in the existing laws are the primary cause for the situation. He pointed out the need for a single regulatory body to look into the regulation of all companies that take illegal deposits from the public.

Eliminating the threat of ponzi schemes: The sound answer

The draft Indian Financial Code (IFC) framed by the Financial Sector Legislative Reforms Commission (FSLRC) presents a comprehensive solution to address the problems of under-regulation. The FSLRC has recommended a clearer and more comprehensive regulatory architecture as compared to what we currently have - RBI would regulate banking and payments, and a Unified Financial Authority (UFA) would cover all other financial services and products. Within this structure, there would be no scope for confusion about who should regulate a Saradha or MMM India as this responsibility would clearly vest with the UFA. This will also bring about more consistency in the regulatory treatment of a range of institutions undertaking similar activities, irrespective of the institution-type.

A central law like the IFC cannot address the problem of dual regulation of cooperative banks, which are regulated by the state governments and the RBI. The FSLRC has recommended that state governments accept the authority of Parliament (under Article 252 of the Constitution) to legislate on regulation and supervision of co-operatives carrying on financial services. Once they do that, financial regulation can fully apply to these institutions.

Defining financial products and services

In the IFC, the definitions of financial products and services are broad and principles-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes (including chit funds) are covered by these definitions. A deposit is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. In Section 2(90), an investment scheme means:

any arrangement with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangement, whether by becoming owners of the property or any part of it or otherwise, to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income, where:

• persons participating in such schemes do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions; and
  
• the arrangement has either or both of the following characteristics:
  • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled; or
    
  • the property is managed as a whole by or on behalf of the operator of the scheme.
  
  
  

Anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the UFA. Accordingly, both Saradha and MMM would be covered under the IFC, the former as a deposit-taking firm, and the latter as an investment scheme. In case of the MMM scheme, a unit of MAVRO is the underlying property in which the members invest. The other tests of the definition are also met as the scheme members do not have the ability to control the unit, which is managed by the operators of the scheme.

The IFC also empowers the central government to expand the definitions of financial products and services. When a new financial product or service is observed, instead of waiting for an amendment to the law, the Central Government can include the new product or service in the definition.

Conclusion

Given the limitations of existing financial institutions in meeting the savings and investment appetite of all Indians, innovations in this field are both inevitable and necessary. However, to ensure that this does not happen at the cost of consumer interests, the scope of formal financial regulation needs to be expanded to include large segments of the currently excluded investment grey markets. This also requires us to move away from the present system of having regulatory responsibilities divided among financial regulators and State Governments. The FSLRC's draft law offers a viable solution in terms of conferring the duty of regulating all investment schemes on a single regulatory body that will be fully accountable for this task. The complete, principles-based framework of definitions, that can adapt over the years, will also help minimise regulatory gaps.

The two escape routes away from domestic formal-sector finance

Three problems afflict formal-sector finance in India today: capital controls, taxation, and financial policy. The most important financial products traded in the formal sector in India -- the stock market index (Nifty) and the exchange rate (the rupee) -- are under enormous pressure as a consequence.

One dimension, that has been emphasised in the existing discussions, is the flight to offshore markets. There is another: the trade goes off into underground markets. These come in two kinds. In the field of commodity futures, it appears that important price discovery and liquidity is found on unregulated markets. As an example, in Gujarat, the town of Bhabhar is famous for having a huge oilseeds and edible oil futures market. Babhar is a true market: it has liquidity and discovers the price.

A second mechanism is a class of market mechanisms which leech off the price discovery of a main market, do not really offer liquidity of their own, and let people achieve trades. In Indian parlance, these are called the `dabba market'. Here is how it works:

1. The main market where Nifty trades is NSE. But if a customer goes there, he has to suffer the full burden of the securities transaction tax, the charge by the NSE member firm, etc.
2. The dabba operator (`DO') sets himself up in business offering trading services in Nifty futures.
3. Many individuals place buy/sell trades with him. These are meticulously tracked; their profits and losses are calculated and money is exchanged w.r.t. each customer.
4. Through this, the DO is effectively accepting orders -- like an exchange -- and doing daily mark-to-market w.r.t. the customers.
5. On average, the sum total of trades by many customers adds up to zero. So the net exposure of the DO is roughly 0. If an exposure builds up, he might choose to lay off his risk on NSE.
6. The DO charges much less than the NSE member since he does not pay STT and his establishment costs are lower.
7. He is a big man in the community. He can break your bones. So you will not default on him. So he charges less margin. This is another attraction - but it means that some fraction of customers endup entangling with the underworld.
8. The DO will work with black money (i.e. cash). This is another attraction, compared with the all-cheques-and-PAN-numbers world of NSE. The short-term capital gains tax (or worse, ordinary business income treatment of winnings) is then avoided.

Bhavesh Shah, reporting from Ahmedabad in DNA, tells us that dabba trading has gotten bigger of late. He also points out that the DOs have been doing some system-building to make their business more efficient. Dabba trading is one response of economic agents to the problems of taxation and improper financial policy. It also happens to a varying degree with trading in India of international underlyings (e.g. crude oil or gold), where capital controls prevent locals from accessing the world market.

In summary, when India makes mistakes on three things -- capital controls, taxation and financial policy -- there are two kinds of responses on the part of onshore and offshore users of India-related financial markets. On one hand, users go off to overseas venues. On the other hand, users shift towards informality. In the limit, large scale mistakes on the three fronts will drive the bulk of customers away from the formal sector onshore market venues. RBI, the tax authorities and SEBI will then lord over an insignificant part of the market.

Important step backwards for pension reforms in India

In the best of times, consumers do badly in personal financial decisions. Here is a stark example of what goes wrong. Mark Hulbert wrote in the New York Times, about research by Choi, Laibson and Madrian, 2010:

MANY index funds track the Standard & Poor's 500, but they differ from one another in one major respect: their fees. You'd think that it would be obvious to investors to pick the fund that charges the least. But you'd be wrong.

In fact, this truth was anything but obvious to a group of elite students. In an elaborate simulation created by several researchers, many students at Harvard and the Wharton School of the University of Pennsylvania failed to select the lowest-cost index fund for their portfolios, even when they were all but spoon-fed the right answer.

There is a problem of consumer protection here.  Financial policy cannot and must not be designed on the premise of caveat emptor, that the individuals making choices are the ones best equipped to look out for themselves. The great bulk of financial regulation is about making the world safer for the individuals making those choices.

These problems are present with insurance and mutual funds in India, where sales practices and product features have been a scandal for a long time, until C. B. Bhave's SEBI started trying to do something about it. These problems would be present to an even greater degree in a nationwide pension system, where participation has two features: (a) To some extent, it would be involuntary; many people would be pushed into pension system participation without self-selecting themselves as is the case with products such as mutual funds, and (b) Whether participants come into a nationwide pension system through voluntary choice or not, they are likely to be less sophisticated than the `elite students' described above, and thus face even more difficult problems of household financial choice.

The key insight of what I term the `second generation pension reforms' is that while we must do defined contribution (DC) pension system so as to keep pension planning away from the balance sheet of the State, we should use public policy decisions about design of the pension system in order to further the goals of consumer protection. One big insight in this is on pricing. Households are seldom able to understand the charges of fund managers. The `elite students' that do fine in comparing an iphone versus an Android phone on features and pricing tend to fumble when it comes to financial products.

The clean answer to this is: Standardise fund management into a group of index funds (one for equities, one for government bonds, etc) and procure fund managers through an auction. This has two consequences: economies of scale (a small number of very large AUMs) and low prices (since fund managers compete with each other in an auction). This idea is found in the original Project OASIS report which designed the New Pension System (NPS), it was successfully implemented by PFRDA when the NPS began, it has been used in other places such as the EPFO, the civil service pension of the US (which is named the Thrift Savings Plan (TSP)), etc. For the back story of the NPS, see link and link. To use Raju Chitale's phrase, we are using public procurement to overcome the market failures of the fund industry.

In this setting, I was disappointed to learn that PFRDA has just announced that they have given up on this key idea of the NPS:

19.1 The PF can fix the Investment Management Fee to be charged to the subscribers subject to a ceiling/cap, as may be prescribed by the Authority from time to time.

I disagree. This loses one of the essential features of the NPS. This makes the NPS closer to the fund management products run by mutual funds and insurance companies. To this extent, the value added of NPS is contaminated: why construct the NPS if households can do this same thing through mutual funds?

It is important to worry about the political economy of finance. The financial industry will generally tend to achieve dominant mind-share within regulatory agencies. The great unwashed masses, the greatest beneficiaries of sound economic policy, will never have a voice in the policy discourse. In India, our puzzle is that of avoiding both extremes: of socialist stagnation (to use Arvind Virmani's phrase) at one extreme, and crony capitalism at the other. PFRDA runs the risk of veering towards the latter.

Uptake of systems like Amazon's `Mechanical Turk' in India

I have long been aware of Amazon's `Mechanical Turk', a mechanism through which tasks are farmed out to a large bank of humans. Each human worker has full flexibility on how many hours are worked and when. From the customer's point of view, Amazon supplies an API and access to a very large pool of humans who can perform small tasks. The median wage is $1.4 or Rs.80 per hour. In effect, Amazon has created a large market through which workers can find work, and firms can find workers to perform well defined tasks.

In a recent issue of The Economist, I was surprised to discover (a) that Amazon's Mechanical Turk has 0.5 million workers and (b) that roughly a third are from India. That's roughly 150,000 persons in India who are plugged into Amazon's Mechanical Turk. We don't know how many hours/week are spent in doing labour supply, but it's still a lot.

There are a few other such systems also. Here are links for exploration: oDesk, CrowdFlower, Elance, Amazon's Mechanical Turk.

These mechanisms add up to a whole new world for the functioning of the labour market. For first world customers who would like to connect up to cheap labour in India, our traditional view was that there had to be a man in the middle - a Datamatics or a TCS or an IBM. What these new systems seem to suggest is that for a certain class of tasks, it is possible to disintermediate the Datamatics or TCS or IBM.

For many individuals in India, the flexibility of working from home without rigidity about how many hours are supplied, and when, these systems could be a big win. At present, many households do not have computers and broadband connections, which is an important impediment. But this is also a constraint that is being rapidly eased through 3G, LTE, etc. These developments, put together, could become a whole new chapter in the story of India's connecting up to globalisation.

The inflationary spiral

When prices are written with a piece of chalk, menu costs are low

Policy and legal review of the Micro Finance Institutions (Development & Regulation) Bill: A new working paper

In response to the Second Micro Finance Crisis in Andhra Pradesh, which took place in October 2010, the Ministry of Finance has proposed a new ``Micro Finance Institutions (Development & Regulation)

Bill''. A new working paper by Shubho Roy, Renuka Sane and Susan Thomas analyses this bill from first principles of economics and law.

A great deal of traditional work in India, in the field of finance and public policy, has been poorly grounded in terms of logical thinking. A variety of government interventions are proposed, without fully showing the rationale for why a given intervention is valuable. I have often scented a socialistic impulse to intervene in the economy based on some vague notions of being a do-gooder. In addition, of course, there are interventions which cater to one special interest group after another.

I feel it is useful to work in a systematic way. The first task is to identify market failures (if any). All interventions must be considered guilty until proven innocent: an intervention must demonstrably tackle a manifestly visible problem. A useful classification scheme in finance is that all financial regulation falls under the three heads of consumer protection, prudential regulation and systemic stability. It is useful to pose problems under these three categories, then propose interventions which address them. At both levels, we need to move away from ex cathedra assertions towards logic and evidence that demonstrates that there is a problem, and logic and evidence that shows that the proposed intervention solves the identified problem without inducing collateral damage.

In the years to come, we need much higher quality drafting of law in India. This process will be assisted if independent analysis in the economy will critique draft law as has been done by the Roy, Sane and Thomas paper. We need more universities and think tanks who will subject all draft legislation and draft subordinate legislation to such scrutiny. On the government side, a greater effort on the formal rule-making process is required, whereby government is able to utilise such comments more effectively so as to strengthen the work.

Household financial choice of the hapless households of India

by Ajay Shah.

In February 2010, I had the opportunity to visit Pudhuaaru KGFS in Thanjavur. This is a remarkable project which helps us see the interface between households and the financial system in a wholly new light.

What a difference 17 months makes! On that visit, I had found a little tenuous Reliance CDMA cover at one place in Thanjavur city. On this visit, I found 3g or Edge cover in many remote places. On that visit, the ride from the airport at Tiruchirapalli to Thanjavur took two hours. This time, it got done in 30 minutes on the new NHAI road, with a peak velocity of 110 kph. While there are many reasons to be gloomy about the problems that India faces, some things are moving along merrily.

The KGFS approach to households and finance

KGFS emphasises the very important idea that for households to correctly engage with the financial system, this relationship must be (a) rooted in high quality advice, (b) which is grounded in a state of strong information about the household. The first is achieved by focusing on the incentives of the front line staff, by pushing them to think about household financial choice in its entirety instead of thinking about one product at a time, and by having no sales commission.

The removal of asymmetric information matters in many ways. On one dimension, if credit is extended to the household, a state of high information helps ensure better credit decisions. But more generally, across an array of financial products, when the advisor knows a lot about the household, the advisor would be able to synthesise an appropriate mix of sophisticated financial products which add up to an improvement in household welfare. In time, the advisor will increasingly lean on an expert system to help him do this better: it's a good approach today and it will get better in coming years.

I think there is enormous value in this approach. I believe that KGFS is doing a great job of building this kind of information about households in their present rollout (which involves going into really small villages at three locations, in Thanjavur, in Uttarakhand and in Orissa).

The typical KGFS front-end is a three-man branch in a village, where the three employees live in that very village. Remote villages in India are an environment of radical transparency. The households are relatively trusting. The three people in the outlet know an incredible amount about the households that surround them. Households and dwellings in small villages are rather stable: there is relatively little action through migration / change in financial conditions, etc. If there was ever an environment where asymmetric information is being removed, it is this.

The line between household finance and small business finance cannot be drawn. An adaptation of the KGFS approach can be quite effective with small business also: the KGFS branch would obtain a full picture of the firm, and deliver a portfolio of financial services to it.

A nice feature of the places where KGFS branches are being rolled out is the lack of alternatives. At a time when Indian financial regulation does not do much to check the behaviour of conventional financial distribution, a few high pressure sales agents can queer the pitch for the KGFS staff. By being in remote places that are being ignored by distributors, the KGFS staffpeople have the luxury of dealing with households without the households being tugged by various high pressure sales tactics of rival sales agents.

Urban households are being mistreated by finance

I also realised some limitations of this approach. Looking forward, India is urbanising. At first blush, it may appear that there is a big problem with the utilisation of finance in rural India. But there are big problems with the utilisation of finance in urban India.

The urban middle class and upper class is deluged with sales pitches by a variety of sales agents of financial firms. But these agents are almost always mis-selling, given their drive to push a product (through commissions) and given their lack of knowledge about the household's overall financial problem. Almost all financial products that are pushed in India (i.e. sold and not bought) seem to be mis-sold. I also feel that when the conversation between a sales guy and the household is about a product and not the overall household financial choice, it is almost always leading to the wrong answers. It's tantamount to a salesman who sells a drug without knowing anything about the patient.

What is out there, in urban finance, is a scandal, and I am embarassed to be an accessory to the crime (in however peripheral fashion). While in Thanjavur, I got the odd sense that at its best, a rural household that's well connected to a local KGFS outlet is doing better on utilising the power of finance, when compared with most urban households who are victims of the sales practices that are mainstream in Indian finance.

In this sense, the real problem for India is not the tawdry state of financial inclusion of the very poor in remote places. The real problem for India -- one that influences the bulk of Indian GDP and the households that matter greatly for India's growth -- is the tawdry state of financial planning of the typical urban household.

The KGFS approach is valuable and important to the places where it's being rolled out. But the burning challenge is that of fixing the mainstream. The mode of India is not brutally poor and isolated; it is middle class urban. Improving the interface between middle class and urban households, and the financial system, matters on a GDP scale.

An unrelated rumination: How important is rural deprivation in thinking about India?

The discussion above is a recurring theme in Indian economics. A variety of incentives (development journals, first world aid agencies, government rhetoric) make it fashionable to emphasise rural deprivation. But India is changing and the sweet spot has shifted. The emphasis on poverty and rural is increasingly off-centre. To stay relevant, and do the most important things in today's India, we have to keep our eye on the ball.

To fix intuition, it's useful to look at the distribution of annual household income, over April 2010 to March 2011, from the CMIE household survey of 143,000 households:

Percentile	Household income
10	45,700
20	59,900
30	72,800
40	90,000
50	112,200
60	142,500
70	180,000
80	240,000
90	348,500

As an aside, I think it's useful for anyone who thinks about India to memorise these nine numbers. Or atleast memorise these three numbers: the 25th percentile is Rs.66,000; the median is Rs.112,200 and the 75th percentile is Rs.208,500.

Middle India today has a household income from Rs.66,000 a year (at the 25th percentile) to Rs.208,500 a year (at the 75th percentile). The old-style Indian story of rural deprivation is (roughly speaking) about the 20% of households who are below Rs.59,900 a year (and the size of that group is shrinking). The main story of India is about the remainder.

An emphasis upon exotic poverty is as misplaced, in thinking about today's India, as an emphasis on designer clothes. Perhaps a bit worse, looking forward, since the extremeties of deprivation are being extinguished by growth, while designer clothes are a superior good.

Urban households are a much harder problem

So it's natural to ask: How can the KGFS approach be applied to urban India? When dealing with the urban poor and middle class, it seems that things are much harder.

Rural households tend to be more trusting, particularly in an environment of ethnic homogeneity and the repeated game that prevails in the village setting. But in urban India, households are more skeptical given the lack of ethnic ties and given the greater experience with people who have finked in prisoner's dilemmas.

Rural households tend to be a stable household in a stable dwelling place. Urban households tend to be physically mobile with greater fluctuations in the household composition.

Until deeper reforms on consumer protection take place in Indian financial regulation, urban households will be constantly tugged by unscrupulous sales agents of financial firms pushing products based on high pressure tactics Even if a KGFS tried to be patient and thorough, the very presence of such high pressure sales tactics would contaminate what a KGFS and its ilk can do.

It is relatively easy to construct information about the economic environment of a farming household (though seasonality and revenue volatility is a serious concern). I feel it may be relatively hard to even put together a picture of an urban household, particular when there is informality of labour supply coupled with entrepreneurship. This makes it difficult to do financial planning for such households.

On the other hand, in urban India, the revenue per household would be higher, and perhaps households could be persuaded to pay for advice qua advice. Or, the government could move on giving out advice vouchers to households, thus spurring the rise of an unconflicted advice industry.

Summary

I think KGFS is a great approach and it will be fascinating to watch them execute their agenda in the really remote places of India. What they are doing is path-breaking and important. This should help us set our sights higher on the problems of urban India. I have traditionally felt gloomy, in the knowledge that most households in India are being scammed by the agents selling financial products. As I look at KGFS, I find myself thinking: Can't we do something like this in mainstream India? I think this is an important question to ask. At the same time, there are some visible hurdles which suggest that this will be hard.

Credits

I am grateful to Bindu Ananth, Ramesh Ramanathan, S. G. Anil Kumar, Kshama Fernandes and K. P. Krishnan for many conversations which helped in improving this post.

Excitement in electronic payments

by Viral Shah.

Frictionless payments are an important contributor to India's growth story. Cash is costly for everyone in the system: for the central banker, banks, businesses, and individuals. Yet, we are far away from a mass adoption of electronic payments.

For electronic payments to take off, it is essential to have a bridge between the world of physical and electronic money, allowing seamless conversion between the two. Until recently, this could only be done at banks or ATMs. Various developments over the last year have greatly expanded the number of entities that can now offer such services:

1. July 2009, Cash withdrawal at point-of-sale guidelines: As a step towards enhancing customer convenience, RBI allowed cash withdrawals at point-of-sale terminals with debit cards.
2. April 2010, Report of the Inter Ministerial Group on the Delivery of Basic Financial Services using mobile phones: This group chaired by the Secretary, DIT and included, among others, representatives from Department of Financial Services, Department of Posts, Ministry of Rural Development, Planning Commission, UID Authority of India, TRAI, RBI, Department of Telecom and the Home Ministry. It suggested a nationwide payments architecture that consisted of a simple centralized account hosting platform as a national infrastructure, full interoperability among payments providers, standards based biometric point of sale terminals, and standards based mobile payments.
3. April 2010, From Exclusion to Inclusion with micropayments: The UIDAI published a strategy document on micropayments, which provides a detailed framework for biometrically authenticated transactions, as recommended by the IMG. The National Payments Corporation of India has developed an interoperability switch for Aadhaar and mobile based transactions as recommended in the IMG report. Both, Visa and Mastercard have also adopted this framework.
4. June 2010, Harnessing the India Post Network for financial inclusion: This report was jointly commissioned and produced by Department of Posts, Department of Financial Services, Department of Economic Affairs and Invest India Economic Foundation. It recommended a framework similar to that recommended by the IMG; that of a low-cost account hosting platform and cultivating a payments ecosystem by allowing partners to access its physical and electronic payments network for a fee.
5. September 2010, Financial Inclusion by Extension of Banking Services - Use of Business Correspondents (BCs): BC guidelines have existed for a while, but RBI recently relaxed the rules for the entities that can act as BCs. These new guidelines allow for-profit companies (except NBFCs) also to become BCs. This appears like a small change but it has had far-reaching consequences.

Over these two years, we have a vivid sense about electronic payments making the grade, from a vaguely posed idea for the deep future to something that is tangibly around the corner. Each of these elements appears to be small in isolation, but the link from public policy developments to outcomes is like a butterfly effect.

These developments have important ramifications for mass adoption of retail electronic payments and financial inclusion. Banks, recognizing the importance of new regulation, have partnered with telcos with retail networks. This allows for the telco to leverage its network of talk-time retailers as BC sub-agents, and to also offer mobile payments between bank accounts. A flurry of announcements has happened recently: SBI-Airtel, ICICI-Vodafone, Axis-Idea, and more will certainly follow.

As much as these announcements are exciting, they raise some worrisome questions. The biggest question is interoperability. If the country is going to have a network of a million BC outlets, shouldn't a customer of any bank be able to use any outlet, much like they can use any ATM? Shouldn't a customer of one bank-telco partnership be able to send money to a customer of another bank-telco partnership effortlessly? Network effects are essential for mass adoption of electronic payments. After all, regulations today allow a person with a debit card to withdraw cash over an interoperable network of point-of-sale terminals.

Banks and telcos are unlikely to want interoperability; to justify investments, gain customers, and want them to stick. Perhaps the regulator ought to take a firm stand on the issue. A good balance may be to ensure that the products are designed to be interoperable with some uniformity of customer experience, but offer an interoperability holiday for the first two years.

Don't like the SKS valuation? Compete, don't complain

by Bindu Ananth and Nachiket Mor.

Much has been said about the astronomical SKS valuations and the personal fortunes of the original investors. Speaking for ourselves personally, we are not at all disturbed by how much money was made by whom. On the contrary, we are very excited that an area that was once thought to be the exclusive turf of, as Monika Halan (http://bit.ly/SquidorDevta) puts it so graphically in Mint, `the nexus of political doles and the rural bank branch system rotting under the weight of corruption and dysfunction' thanks to pioneers like Vikram Akula, Padmaja Reddy and Udaya Kumar, has moved firmly into the domain of `mainstream commerce'.

People forget that we are a country of over 500 million very-very poor people, so very large amounts of equity capital are required in building an ecosystem of financial firms which will serve the poor of India. Now that the ball has been tossed up high in the air we are hoping that other people who also know how to build India sized businesses (Ratan Tata, Kumar Birla, Mukesh Ambani, Sunil Mittal, Azim Premji and several others) take notice of this ball and hit it with all the power that they can bring to it. Curiously, the fact that so much money was made and was seen to be made is good news because this kind of money even makes the big boys sit up and take notice. Preventing Vinod Khosla or Vikram Akula from making some money is not going to eradicate this poverty, but the power of their ideas taken to scale will.

Should we then not be concerned at all about how much money was made? For sure! Not because somebody got rich but because it calls into question the oft-stated MFI position that their high interest rates are only just about covering their high operating costs. A paper (http://bit.ly/Nvw6k) by Chaudhary and Rai shows that valuations are very sensitive to interest rates. They show that just a 1% decline in MFI interest rates leads to a Rs. 1.5 billion drop in valuation for an MFI with 500 branches. They also show that should the large MFIs choose to cut interest rates by as much as 10% (from the over 30% per annum that most of them currently charge, to under 20% per annum), they would still deliver a holding period return on equity of over 25% per annum. The focus on individuals making money distracts our attention from this very important fact.

And attempts that are intended to bring about `orderly conduct' (http://bit.ly/MFINCode) could have the consequence of preventing competitive forces from coming in and bringing these rates down there is a real need to make sure that this does not happen and to actively encourage intense competition amongst new and existing players. Experience, for example with housing finance in India, shows that this was the only reason why the rates fell and services standards improved without any dilution of credit quality. There is also an urgent need to bring in completely new models of financial services for low-income households (we are associated with one such attempt: www.bit.ly/LocalTouch). For example, the rapid scale-up of ATMs in India changed the entirely banking landscape by changing the very nature of the service models.

Bindu Ananth (bindu.ananth@ifmr.co.in) is the President of IFMR Trust (and the corresponding author). Nachiket Mor is the non-executive Chairman of the Governing Council of IFMR Trust and the President of ICICI Foundation for Inclusive Growth. Views are strictly personal.

Post offices and financial inclusion

An expert committee report: Harnessing the India Post network for financial inclusion has been released. This is a joint effort between Department of Post, Department of Financial Services, Department of Economic Affairs and Invest India Economic Foundation. It has some interesting new ideas on the unique role of post offices in financial inclusion, and the way to best harness these strengths while retaining a useful sense of the public/private divide.

Also see:

• Souvik Sanyal in the Economic Times, 29 July 2010.
• Stamps, savings, microloans and more, on the IFMR blog, 10 August 2010.
• Post offices can bring in financial inclusion, by Sanjeev Kumar Patro in the Indian Express, 3 August 2010.
• Irda’s plan to sell insurance products through post offices hits roadblock by Remya Nair and Surabhi Agarwal, in Mint, 28 February 2011.
  

Addressing the problems of Rupeezone

While everyone is pondering the ways in which Eurozone is not an optimal currency area, I found myself worrying about the ways in which Rupeezone is not an optimal currency area. In the Financial Express today, I have a column: Addressing the problems of Rupeezone.

Here are interesting materials on Greece which set the stage for this:

• A money too far by Paul Krugman, in the New York Times.
  
• A response by Greg Mankiw on his blog. He refers to this AER article from 1986 by Christine Romer, and this article by Christopher Hanes in AER in 1993.
  
• A response by Paul Krugman on his blog.
  
• A blog post by David Beckworth.
  
• On the subject of labour mobility, Casper van Ewijk and Michiel van Leuvensteijn have an important column on voxEU making the link between labour market mobility and the transactions taxes which governments impose on real estate transactions.
  
• Here is a column by Feldstein on these issues back in 1998.
• Greek lessons for India, in the Business Standard, by Suman Bery.

This is an interesting demo of how economics happens today: an interleaving between journal articles, newspaper columns and blog posts.