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Financial inclusion: Concepts, issues, and policies for India

The International Growth Centre recently brought out a synthesis paper (Singh 2017) that lays out the basic concepts surrounding financial inclusion, and reviews a wide range of IGC and other studies on financial inclusion. At a workshop organised by the IGC in collaboration with Ideas for India and Indian Statistical Institute, Rohini Pande (Harvard Kennedy School), S. Krishnan (State government of Tamil Nadu), Ashok Bhattacharya (Business Standard), and R Gopalan (ex-Ministry of Finance) discussed the key lessons emerging from research, implications for policy, and areas where further work is needed.

Financial inclusion or access is a component of financial development, along with depth, efficiency, and stability. Financial development is important for economic growth, and financial inclusion in particular, has a bearing on equity as well.

Access to a transaction account is a first step towards broader financial inclusion as it serves as a gateway to other financial services like credit or insurance; lowers transaction costs for daily economic activities; allows for planning for longer-term needs; and enables the creation of a buffer for emergencies.

Other potential benefits of financial inclusion include: improving efficiency and targeting of government welfare programmes; reducing corruption and terrorism more broadly, through better monitoring and regulation of financial transactions using digital technology.

Why financial inclusion is important: The macro context

Elaborating on Prof. Singh’s presentation, Rohini Pande highlighted some of the key macro trends in India that should influence how we think about financial inclusion. Roughly 70% of the world’s poor now live in middle-income countries, including India. Public social protection spending in these countries is low, and health shocks remain one of the most important reasons why households re-enter poverty once they escape it. Thus, people need to be given a long-term ability to deal with shocks, and to make the human and financial capital investments required to enable steady income. Moreover, India is experiencing ‘jobless growth’; entrepreneurship, particularly for women, has been the key form of employment outside agriculture – and that depends heavily on access to finance.

Does access necessarily lead to inclusion?

There is agreement that while access is a first step towards inclusion it does not necessarily lead to inclusion. According to Ashok Bhattacharya, the Indian experience bears this out very well: by giving access to people through bank nationalisation in 1969, inclusion was not achieved. In Prof. Pande’s view, we currently run the huge potential danger of doing for financial capital what we did for human capital for several years: similar to school enrolment or number of hospitals in a district, we are now going to start counting it up by bank branches or PMJDY (Pradhan Mantri Jan Dhan Yojana) accounts. It is important to note that access is not usage.

Prof. Pande said that one reason for the focus on access is that it can be measured: “We need to begin obtaining metrics from administrative data that tell us about impact – while maintaining citizen confidentiality.”

Components of financial inclusion

Banking is the foundation of much of financial inclusion. While studies in other countries show mixed results, the impact of increased access to banking in India has been found to be mostly positive. A national state-level study shows positive impacts of bank branch expansion on the poor and disadvantaged (Burgess and Pande 2005Burgess, Wong and Pande 2005). Expanded bank access leads to increased economic activity (Young 2015), as well as savings (Somville and Vandewalle 2015).

Research shows that organisational structures within lending institutions matters. Cole et al. (2015) and Field et al. (2016), in very different contexts, highlight the importance of organisational innovations that improve incentives within the sector.

Across the developing world, the evidence on microfinance is mixed. A review of six randomised evaluations of microcredit by Banerjee, Karlan and Zinman (2015) suggests that there is a “consistent pattern of modestly positive but not transformative effects”. Over a period of several years, microcredit by SEWA Bank in India has helped integrate women into the labour force, through greater participation in household business activity. Possibly, there are broad impacts on fertility as well (Field et al. 2016).

Some studies have analysed the financial sustainability of the microfinance model. For example, Cull et al. (2016) find that subsidies, while common, may not always be necessary.

Details of design of microfinance interventions are found to be crucial. Looking at contract design, Field et al. (2013) show that allowing for a grace period between loan disbursement and beginning of repayments increased short-run business investment and long-run profits. While it did raise default rates, the net welfare effects seemed to be positive.

Small-firm finance
Small firms are typically credit constrained and they tend to do better when the constraint is eased (Banerjee and Duflo 2008). In a comprehensive analysis of very small firms in India, Raj and Sen (2013)find that finance constraints play an important role in firm transition from family-labour-only firms to small firms that use hired labour, and even more so for the growth of the latter beyond six workers. Current government policies do not seem to be helping in this regard.

Research implies that there is much to learn in India about the specifics of relaxing financial constraints for microenterprises, up to more substantial small and medium firms, including contract design, monitoring and enforcement, and training (see, for instance, Barboni 2016).

Agricultural credit and insurance
Agricultural credit tends to be a political issue, and the overall evidence suggests that it is inefficiently and insufficiently allocated (for example, Sharma and Kumawat 2014).

How can the effectiveness of agricultural credit be enhanced? Details of market institutions and incentives are important. For instance, in a field experiment with trader-agent intermediated lending (TRAIL), Maitra et al. (2014) find that TRAIL loans were more successful than conventional group-based loans (GBL) in increasing production of leading cash crops and farm incomes. This is because farmers selected by agents were more able than those who self-selected into the GBL scheme.

Another study (Mitra et al. 2012) found that integrating credit with better information and access to markets may improve the bargaining power of farmers. Hence, Interlinking of markets matters in agricultural credit.

Studies from various countries indicate that farmers’ insurance can have positive impacts if attention is paid to details such as farmer liquidity (Gine 2009) and price sensitivity of demand (Takahashi et al. 2016); and possibly if interactions between insurance and credit markets (Karlan et al. 2011) are taken into account. There is recent evidence from India that well-designed farmers’ insurance can be sustainable and effective, and benefit landless agricultural labourers as well (Mobarak and Rosenzweig 2013).

In an experiment with different methods of marketing rainfall insurance to small-scale farmers in Gujarat, only a money-back guarantee had a consistent and large effect on farmers’ purchase decisions (Gaurav et al. 2011). This implies that building trust in concrete ways matters.

Commenting on the issue of farm loan waivers, Mr S. Gopalan said that if the loan amount is adequate; consumption loans are provided to farmers; there is robust insurance to address crop failure; and structures are in place to enable farmers to access markets and get the right price for their produce – perhaps the demand for waivers would not arise.

Health insurance
Both in India and other countries, the evidence on the benefits of community-based health insurance for the poor is mixed; it varies by time, location and implementation of interventions. Banerjee et al. (2014) conducted an experiment with the largest microfinance institution in India, which suggested that bundling microcredit with health insurance did not seem to work. On the other hand, a Bangladesh study (Islam and Maitra 2012) indicated that microcredit by itself provided a cushion against health shocks by reducing the need to sell livestock. Here too, there are a great deal of complexities and interactions.

Health insurance is a credence good, making trust important. Debnath and Jain (2015) show how caste networks may be used to drive acceptance and adoption of health insurance.

Leveraging technology

Payments technologies such as Kenya’s M-PESA can enable more money transfers and consumption smoothing (Jack, Ray and Suri 2013Jack and Suri 2014). While market dominance enabled easy roll-out of M-PESA, lack of competition may reduce access (Kendall et al. 2011).

There are several other digital payments schemes across countries: more research is required on infrastructure, regulation, and design. In India, digital payments are conceptualised as one component of a three-part strategy for financial inclusion using digital technologies, namely, JAM – Jan Dhan (banking), Aadhaar (identity), and Mobile (transactions). While there is evidence that biometric identity cards can reduce corruption (example, Muralidharan et al. 2016), there are concerns that the JAM framework may be too restrictive in thinking about financial inclusion via digital innovation (Ravi and Gakhar 2015).

Mr Bhattacharya said that the current focus on JAM in India needs to be reviewed in the larger context of how it is playing out. Lack of financial literacy seems to be coming in the way of JAM becoming a success. According to Mr S. Krishnan, in distributing government benefits directly through bank accounts, there are convenience issues in terms of last-mile connectivity. Hence, outreach is one area that needs to be addressed in the review of JAM.

Technology can also be used to address the issue of behaviour of loan officers in the context of loan appraisal, said Mr Krishnan. The decisions seem to be based on face value or personal connections. If there is a credit information linkage, loans can be given out taking into account the applicant’s credit record.

There is consensus that while technology can indeed do a lot, it cannot replace certain points along the chain where humans are necessary. Prof. Pande remarked that this is particularly true in the case of imparting financial literacy, and it is very important to think through implementation and incentives carefully.

The receiving end

On the demand side, financial literacy is an important factor that shapes financial inclusion. Financial literacy is complex, and remains a challenge even in industrialised countries (Lusardi and Mitchell 2014). Overcoming information asymmetries is not easy (Alan et al. 2015). Financial education programmes often don’t work (Miller et al. 2014), though rule-of-thumb guidelines may be more effective (Drexler et al. 2014). In a study on a life insurance product in India, Halan and Sane (2017) find that consumers may lose focus with ‘too much’ information and that information is more likely to be valuable if it is understandable in the context of prior financial literacy. The existing evidence seems to suggest that financial education is difficult but achievable, and more work needs to be done in this area.

Besides, there are behavioural factors such as difficulties of commitments in savings (example, Ashraf et al.20062010); myopia or procrastination (Duflo et al. 2011); and inefficiency in business decisions (example, Beaman et al. 2014). These studies from Africa imply that careful attention needs to be paid to behavioural distortions while designing financial inclusion programmes. Gangadharan et al. (2014) analysis of Bihar’s rural livelihood project JEEViKA provides the lesson that it is important to factor in social considerations and individualistic anomalies.

Prof. Pande said that the mixed evidence on the impact of the instruments of financial inclusion is partly a reflection of the fact that instruments function very differently for different populations. A bank branch is going to have a very different effect for middle class vis-à-vis the poor. We may think of informal sources of finance as bad for the poor but the rich prefer may prefer them due to the flexibility – not because they lack collateral.


In a fast-growing, increasingly unequal country, the process of providing citizens access to financial instruments is complicated. In a scenario where there are different populations with different needs for financial inclusion, and private players are mainly focussed on the middle class and rich, it is important to carefully think about the role of regulation.

Mr Gopalan said that regulation for big, formal financial institutions needs to be totally different from that for small and informal institutions. The light-touch regulation for microfinance institutions in India did not go well with market forces that were propelling these institutions to generate returns. As a result, the interest rate shot up, leading to protests by society. Hence, societal regulation comes into force as well and this needs to be accounted for in research studies. Financial literacy can help in this context. Besides, when thinking about regulation, we also need to consider the various informal financing structures that exist, such as social groups or communities that lend and borrow amongst themselves, local money managers, etc.

This blog first appeared on Ideas for India


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