ISB Updates

Perspectives: Raghuram Rajan in conversation with Rajesh Chakrabarti

Challenges of Financial Inclusion

One of the highlights during the CAF organised Indian Banking Conference, at the ISB, was a special address on ‘Indian Banking Sector Reforms’ by Raghuram Rajan, Chair of Committee on Financial Sector Reform, Planning Commission, and Eric J Gleacher Distinguished Service Professor of Finance, University of Chicago. Rajesh Chakrabarti, Assistant Professor Finance, ISB, met with Professor Rajan to discuss the policy and implementation challenges of financial inclusion. Policy interventions like priority sector lending, interest rate ceilings and micro-finance and their impact on financial inclusion, were also deliberated upon.

ISBInsight: When we think of financial inclusion, we think primarily of reaching credit to the poor. In your mind, in what financial services has inclusion been the most lacking and where is it most critical?

Raghuram Rajan: We should be very careful in saying this is for the poor because there are a lot more people in India who are excluded, including people whom you would think as lower-middle class or middle-class. There is a problem in reaching our financial services to everyone, but we should be wary of forcing credit. It’s not clear if everyone can handle credit. Making it easily available before people can handle it only results in indebtedness. First, people need to figure out how to manage their finances and a good way is to start a savings account. It is important that we make savings accounts available to everyone. It is like a fundamental right for people to be able to put away money in safety. It is essential for people to have the ability to save or invest in a way that they get real returns as opposed to negative returns, which is the history of poor Indian household. Similarly they should be able to get insurance, and possibly, pension.

I: Some financial institutions prefer to give people an opportunity to save even if it gave negative returns. Would that be acceptable?

R: For want of an alternative, yes. Choice is always a good thing. It could be even better if it wasn’t such a high cost activity and there was competition so that the providers could give at least a decent return on savings. There is a sliver of the economy, which is benefitted from this huge rise in the stock market, probably a thicker sliver which would be benefitted from the rise in land prices but we must remember that there is a huge sliver which has not benefited from the asset wealth generated by this new economy.

I: Generally financial inclusion is thought to be an objective to be pursued by public sector banks. What role do you see of private sector financial institutions in promoting inclusion?

R: This goes back to the notion that financial inclusion is an activity that has to be subsidised, that it has to be forced as a form of charity and therefore is a public service conducted by the public sector banks. I think there are certain aspects of providing financial services, which will probably need to be subsidised, but not necessarily all of them, provided some of the constraints are removed and the government creates the necessary infrastructure such as access to information, access to legal support, etc. The government should make sure that the individual customer is seen as attractive and not as a charity case. This is the philosophy in CK Prahlad’s “fortune at the bottom of the pyramid”, but I want to admit that it is not true that there is a fortune at the bottom of every pyramid. In situations where there isn’t a fortune, let us find appropriate ways by targeting the subsidies in the right way and by providing incentives to the private sector to reach out in the right way.



R: You have to use the existing distribution networks because they are cost effective in what they are doing and over-laying the financial sector component would be of relatively low cost. That seems to be the most effective way of bridging the last mile. You have to make sure that the channel you are using is financially competent, and is safe, these are not insurmountable problems. Making multiple uses of the same channel and using technology to reduce transaction costs and linking remote areas in a reasonably safe way could be another way of bridging the last mile. It is hard to bridge the last mile without having a local person like a local creditor, where we need to think of appropriate ways.I:The “last mile problem”— the exorbitant costs of delivery – is perhaps the biggest challenge in promoting financial inclusion. What suggestions would you make to reduce this cost?

I: The priority sector lending norms were based, at least in part, to promote financial inclusion. Why have they not worked and how can we raise efficiency in these loans?

R: I don’t have much expertise here. I wish there were more studies on the effectiveness of the priority sector on lending. My friend, Nachiket Mor (1), tells me that without priority sector lending, banks would not be that interested in rural areas. He believes that priority sector lending is necessary to force banks to focus on rural areas. But I do know that urban areas too have a priority sector problem. The poor in urban areas are equally excluded and now that the migration is happening from rural to urban areas, it is going to become an increasing problem. There are other ways of doing it more effectively but whatever the effectiveness, can you do it better? - that is what the Report (2) has focussed on because we don’t really know whether it has been effective or not. The government being in the business of determining which areas are important and which are not, should really be the thing of the past. Defining, for example, students’ wanting loans to go abroad as a priority sector, to my mind, is over-rated. We are saying, let’s subsidise our kids who are going abroad although it has nothing to do with the larger interests of the masses, who are excluded even by the nature of their education.
I think we should make full use of the fact that priority sector lending can’t be wished away. We should just move it to a most efficient lender. You may ask, “If it is credit worthy then why isn’t it getting the credit?” and I think the answer is that it is not credit worthy, given the cost structure of the banks. But it might be credit worthy to some other institutions. We should exploit that facility to make it more efficient and leave the question of whether it is a good thing or not, till we have a political will to address it.



I: Relatively higher interest rates charged by MFIs and rural lenders have often attracted media and regulatory attention. What are your views on the appropriateness of interest rate ceilings?

R: From empirical observations, if you have a cap, people whose real cost of capital is higher than that will not able to borrow at rates below that cap and so they are forced to migrate to the money lender who is not constrained by that cap. So people end up borrowing at much higher interest rates. It’s an asymmetric thing, it is a discontinuity. So the point of the Committee (3) is simply to reiterate what Narsihmam (4) said so many years ago. He had amazing insights. I think that students should be forced to read it in the classrooms; if we had done what Narsihmam said, we would have been in a much better position. The point is that people want quantity, people are willing to pay high interest rates if they get the quantity. There are different kinds of loans that are made by money lenders, they provide immediacy, there is also no collateral backing. It is not easy for banks to process information intensive loans. We need to utilise the social pressure that micro finance institutions bring and have local bodies to make those kinds of loans with just local information. Interest rates caps may stand in the way. It is politically unpopular to say that, let’s remove the interest rate caps and let these guys be hounded by the money lenders. This is in in-fact what is happening and this is why the evidence is so important. You are anyways not protecting people from the money lenders, you are actually driving them into the hands of money lenders!

I: Loan pushing, without raising absorptive capacity of the poor, can lead to extremely unwelcome situations including suicides. In what ways can real sector developments aid financial sector inclusion?

R: The idea of the cell-phone as an important business tool for creating entrepreneurs has been one of the most problematic sources of advertisement for the micro-finance sector. It seems to suggest that there is an entrepreneur in each one of us, if only we could get the credit. This is the biggest fallacy that seems to be propagating in the West. Aid is disreputable, charity is not! Entrepreneurs want to create other entrepreneurs like themselves, they want to become an angel investor. But, not everyone can become a darzi (5) just by owning a sewing machine. The real problem is that, most people don’t have basic business skills. You need to think of businesses that use local skills, therefore, you need skill development as well. The first attempt to tackle poverty is to provide appropriate education or vocational training or skill based education and then give people the finance to start a small business. We should also accept that if we give out credit more freely, then most people are going to increase consumption first. They are not going to become productive entities as a result of the credit. There is a lot of hype around access to credit which may unfortunately become a problem. Self Help Groups ( SHGs) were very good initially but now the politicians are getting into the act, ‘benami’ (6) SHGs are being created. It’s free money and everybody wants a piece of it! So the recovery rates are down to 50%. I firmly believe in the fact that, once you get the government into the act into these things, once you get the desire for showing numbers that you have increased the SHG loans by so many, it will immediately vitiate the culture.


  • Nachiket Mor is the Deputy Managing Director of ICICI Bank Limited. Mor is responsible for government banking, agriculture, rural and micro banking, social initiatives, proprietary trading and implementation of best practices in risk management on a group-wide basis
  • Narasimhan Committee Report on Indian Banking Reforms, 1991 and 1998
  • Narasimhan Committee
  • M Narasimhan, Former Governor, Reserve Bank of India
  • Hindi word for tailor
  • Hindi word for a fictitious name