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Integrate Credit Markets to Tame Inflation

R Vaidyanathan*
The mostly unorganized and noncorporate sectors like transport and trade constitute major drivers of economic growth in India. Yet, by and large, they have no legitimate channels to access credit, and come to depend on the too costly nonbanking financiers that also include money-lenders at the bottom level of the private money market where rates are sky-high. Eventually, reduced to simple arithmetic, the common man has to shell out anything from 35 % to 80% more than the producer price for his consumer goods. If this economic situation is called the galloping inflation, one main culprit is, therefore, the prevailing credit conduit. It is all the more frustrating as huge funds are lying idle with the banks and Govt institutions. The Govt has had enough of committees but a solution has been elusive. Here below are some proposals:

ndian businesses and entrepreneurs are provided credit by a plethora of sources. It ranges from foreign banks (FBs), public sector banks (PSBs), old private sector banks, new private sector banks, cooperative banks, non-banking financial companies (NBFCs), un-incorporated bodies (UIBs) and relatives/friends etc. The form and size of the organization decides the source. If it is a proprietorship or partnership it uses non-banking channels compared to a large public limited listed company which uses PSB or FB credit. The size also mostly decides the rate of interest. A flower vendor gets funds at much higher rates compared to the listed companies. Not only that. There are problems associated with access to funds. Nagamma has been a flower vendor for more than twenty years in my suburb of Bangalore. Several times she joined informal chits to save some money and generate loans during need. Many times the persons who ran the chit ran away. As a finance professor, I thought I

*R Vaidyanathan is Professor of Finance and Control, Indian Institute of Management, Bangalore.

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should do some good in the world of practical finance and advised her to open an account with a commercial bank for saving her hard earned money and perhaps get a loan later. The branch manager who is a pleasant lady knows the flower vendor for many years. But the Core Banking Solutions (CBS) with its central server located at Davos or Basle will just not recognize Nagamma even though the manager knows her. It was pointed out that the system decides about accepting new customers under the Know Your Customer (KYC) model. The manager knows the customer but it is not enough, the system should recognize her using multi-factor discriminative model of non-linear credit rating. She was asked photos, proof of address, pan number, proof of date of birth, references and also given exotic choices of using debit card and net based banking. It is sad that banks have moved away from the community-based recognition of new customers, particularly small entrepreneurial classes.

The phenomenal growth rate witnessed in the last few decades has been facilitated by significant increase in our savings rate and large portion of our savings rate is from the household sector. We have provided in Table 1 the share of savings by households (which includes proprietorship and partnership firms), Government and Private Corporate sectors. We find that more than 80 percent of our savings come from household sector and if we look at the composition of financial savings by households at least one-third is held in the form of deposits in banks. The share of household sector in outstanding bank credit has come down to 47% from 58% between 1990 and 2004 [See table 13Increasing Concentration of Banking OperationsEPW Research Foundation, March 182006; EPW, Mumbai] during which the household sector in trade, transport, construction, restaurants, and other business services has been growing at more that 8% CAGR. Here, households

Table 1
Savings Rate and Contributions by Different Sectors. [%] Items/Year Govt. Pvt. Corporate Household 1970-71 2.9 1.5 10.1 1980-81 18.9 3.4 1.6 13.8 1990-91 23.1 1.1 2.7 19.3 2000-01 23.7 (1.7) 3.8 21.6 2008-2009 32.5 1.4 8.5 22.6 GDS [as of percent of GDP] 14.6

Note: GDS: Gross Domestic Savings, GDP: Gross Domestic Product, GDP is at current market prices. Source: National Accounts Statistics: various issues; Central Statistical Organization, New Delhi

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include agricultural households and to companies would continue to be classithat extent the fall is very significant. fied as loan and investment companies. Hence the growth rate of the nineties of In the proposed structure the following the economy is not related to the credit categories will emerge, namely, asset financing company, investment commechanisms of the banking sector. It is not only lazy banking but also pany and loan company. banking with significant structural disThis brings out the need to have a tortions. The share of private corporate comprehensive approach towards the sector in national income is around 12 to non-banking sector in the credit 15 % but it takes away nearly 40% of the market instead of looking at issues in a credit provided by the banking sector. piecemeal fashion. The non-banking The fastest sector consists of The Reserve Bank of India has growing non-coran assorted group re-grouped the asset financing porate sector gets of entities regunon-banking financing companies lesser share of lated by different (NBFCs) engaged in financing real bank credit, which agents with the and physical assets supporting reveals that the stress more on economic activity as asset financing non-banking regulation rather companies (AFCs). financial sector than on develop(NBFS) is playing increasingly impor- ment of an integrated financial market. tant role in the credit delivery mechaWe also have the unincorporated nisms of the growth of the economy. bodies which are money lenders and are The Reserve Bank of India has re- regulated by respective state governgrouped the asset financing non- ments, including the rates and other banking financing companies (NBFCs) covenants. The chits are also under the engaged in financing real and physical Registrar of Chits of the state assets supporting economic activity Governments and Nidhis are under the such as automobiles, general purpose Department of Company Affairs. There have been many committees industrial machinery as asset financing companies (AFCs). The remaining and groups formed over a period of time
The safe way to double your money is to fold it over once and put it in your pocket. Frank Hubbard

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to develop the non-banking sector so lenders and 25 percent in the case of that an integrated credit market urban households. (See - Household emerges. But unfortunately the focus Indebtedness in India; Statement 6; seems to be on regulation rather than page 25; NSS, Ministry of Statistics and development. Particularly after the bad Programme Implementation, GOI, New experience with some of the NBFCs in Delhi; December 2005). Hence we need the late nineties the focus has signifi- to recognize the importance of the entire cantly shifted to the liability side of the spectrum of non-banking sector rather than in a segmented fashion. entities rather than on the asset side. The non-banking sector plays a very important and crucial role in financing Asset-Based Versus Income-Based activities which are the engines of our Lending It is to be noted that the market economic growth like non-railway transport (trucking). Hotels and restau- knowledge and information regarding these activities are rants, wholesale There is a huge informal sector of not fully available trade and retail money lenders which provides with commercial trade and other substantial portion of credit banker on an services are not to requirements of the economy. 43 updated basis. The be ignored or percent of debt of rural households typical bank manglossed over. They and 25 percent of urban households are from money lenders. ager of public play a vital role in sector bank has a our economy from the smallest money lender to large cor- two to three-year tenure in a particular porate entities and there is a need to rec- branch and is also shifted across activiognize it and focus on the development ties like foreign exchange, administraof this sector and in the process tion, agricultural finance, personal strengthen the credit availability for the banking, training, industrial lending etc. By and large the public sector banks non-corporate sector. Other than these NBFCs on which have been geared to asset based data is provided by the RBI there is a lending rather than lending based on huge informal sector of money lenders the forecast cash flows. This is all the etc which provide substantial portion of more true of such activities like trade, credit requirements of the Indian transport, hotels and restaurants, coneconomy. We find that 43 percent of struction, etc where there are significant debt of rural households is from money- fluctuations in the cash flows on a daily

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basis. In other words, risk assessment at the retail level. The credit availed by capabilities are not adequate in the con- these sectors comes from sellers in the text of these activities. Also, funds need form of payables/ receivables or from to be available to these players without open market, ie non-banking sources much paperwork and based on personal and from bank sources. The financing assessment. These activities are mostly of the activities undertaken by the nonfinanced by the non-banking finance corporate sectors particularly in areas sector (NBFS) consisting of companies like trade (wholesale and retail), hotels in chits and similar activities and un- and restaurants is mainly from the priincorporated business entities (UIBs) vate money markets where the rates of interest are much higher, at least twice known as money lenders. Unfortunately, there is no direct esti- that of the government bank. These are on cash flow mate available A significant role is played by the based lending about the credit non-corporate financing bodies in our rather than on provided by the economy and the rates are much asset base and are non-corporate higher than that charged by the undertaken more bodies for trade commercial banking system due to by the unincorpoand commerce in ease of transaction and trust based lending. rated type of the economy. financing agenElsewhere we have estimated that in trade alone the cies. The organized non-banking sector role of non-banking institutions in credit is more in asset based lending for items provided might be of the order of sev- like equipments, trucks etc. This is one enty percent. Hence a significant role is of the major reasons for the large marplayed by the non-corporate financing gins seen in trade, both wholesale and bodies in our economy and the rates are retail and ultimate retail price. For much higher than that charged by the many of the fast moving consumer commercial banking system due to ease goods (FMCG) we find the gap between the company balance sheet of transaction and trust based lending. The result is segmented distribution figure and the street price figures to be system and prohibitive financing cost more than 35% and one factor in this is
We can tell our values by looking at our checkbook stubs. Gloria Steinem

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the open market interest paid by the plumber, carpenter, fitter, painter, etc trade channels. In the case of cash gets funds at 3 to 4 percent per month. The segmented financial markets crops and vegetables the gap between producer prices and consumer prices present an ironical, if not tragic, picture can be as high as 70 to 80%. Here again of huge funds available with bankers on the financing cost both for holding and the one hand and prohibitive interest rates at which funds are accessed by transport plays a major role. In the recent past, the interest rates trade and commerce, particularly the have been moving south and many a non-corporate sector, on the other. As large corporate is in a position to access already seen, the non-corporate sector funds from banks at less than ten per- has dominant role in activities like trade cent. But my flower girl and my veg- (whole sale and retail) construction, etable vendor get it at half percent per hotels and restaurant, private transport day. (Returning half rupee for hundred and other services, Hence we are not rupees borrowed in the morning). This talking here of some residual segments. These secwill work out to be There is need to integrate domestic tors constitute more than 180 financial markets through a system of percent per making un-incorporated bodies (UIBs) nearly thirty percent of our annum. My retail in the credit market as channel economy and they provision stores partners to large banks. are the fastest man gets it in an interesting way. He gets Rs 45,000 (for growing service sector in the last a loan amount of Rs. 50,000) up front decade, mostly above 8 percent per and pays Rs. 500 per day for 100 days to annum. The cost of funds at which they repay Rs. 50,000. It turns out to be more borrow adds to the inflationary trends than ten percent for three months. My since they need to pass it on to the ultibarber gets it through a local chit mate consumers. process at around 4 percent per month. The fast food restaurant (Idli joint) at Concentric Circle of Banking the corner of the road gets funds at 3 Institutions There is need to integrate domestic percent per month from a non-banking agency. The private bus operator in the financial markets through a system of suburbs gets it at two and half percent making un-incorporated bodies (UIBs) and the construction contractor near in the credit market as channel partners home gets it at 3 percent per month. The to large banks. The reforms have

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focused only on the liability side of partnership/ proprietorship groups and NBFS and failures therein, but the asset monitor them and recover the money side is equally important in terms of lent to them. Hence, the public sector banks could credit delivery to large segments of our finance the non-banking financial instieconomy. The significant role played by the tutions on a wholesale basis and they in non-banking institutions in the credit turn could fund the requirements of the delivery mechanism has not been appre- non-corporate sectors in a chain of ciated nor fully understood by the retailing credit and recovery functions. policy planners. The focus is more on If the banks finance the NBFCs after failure of some The public sector banks could finance rating them even institutions. There the non-banking financial institutions at 4-5 % above Lending have been failures on a wholesale basis and they in turn Prime could fund the requirements of the Rate (PLR) then in the non-banking non-corporate sectors in a chain of these institutions sector in terms of retailing credit and recovery could fund the institutions in both functions. non-corporate corporate and sector at perhaps 8-10% over and above other forms of business. In a sense the non-banking finance the PLR. This would still be lower than companies both corporate as well as the open market rates of two and half to non-corporate are the best route to three times the PLR at which this sector, finance these activities of the non-cor- in many of these activities is getting porate sector particularly for future financed. The financing to the non-banking income based lending. This is due to the fact that in their area they are market organizations (both corporate and uninsavvy and have the ability to rate the corporated) by the commercial banks

Inflation hasn't ruined everything. A dime can still be used as a screwdriver. H. Jackson Brown, Jr. I am opposed to millionaires, but it would be dangerous to offer me the position. Mark Twain

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should be treated on par with priority tionship between size of borrowings and sector lending as long as the end use are the cost of borrowings without much to these sectors. This implies that the application of credit rating of the borcommercial banks gear themselves, in rower. It would also facilitate creation rating the non-banking organizations of proper database in these activities for rather than thousands of unincorporated credit rating of these entities. The efforts of banks to deal with self entities in trade, transport, construction, help groups (SHGs) have been very sucand hotels and restaurants. In the case of non-corporate entities in cessful in some of the states particularly the market, the commercial banker can where these groups have women in be given the powers to license them and majority. The recent efforts by the provide credit to them to reach the Government to encourage banks to reclarger market. It can also be specified ognize the business correspondence that only licensed non-corporate bodies model augurs well in this direction. In will be permitted to operate in the credit January 2006, the Reserve Bank permitted banks to market in terms of The efforts of banks to deal with self utilize the services collecting deposits help groups (SHGs) have been very of NGOs, MFIs and also availing successful in some of the states than of loans from the particularly where these groups have (other NBFCs) and other banking instituwomen in majority. civil society tions. This would provide opportunities to banks to organizations as intermediaries in proenlarge their scope of operations and viding financial and banking services also provide the Un-Incorporated through the use of business facilitator Bodies (UIBs) to carry on their busi- (BF) and business correspondent (BC) ness with loans from the banking models. The BC model allows banks to system. It will also introduce orderli- do cash in - cash out transactions at a ness in terms of banks rating these enti- location much closer to the rural poputies for licensing them and reviewing it lation. The Reserve Bank has been encourannually. The depositors are also protected to some extent in the context of aging the use of ICT solutions by banks assessment by the commercial banks for for enhancing their outreach with the help of their BCs. Banks have been licensing them. This concentric circle of banking will urged to scale up IT initiatives for finanbring to an end the current inverse rela- cial inclusion speedily while ensuring

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that solutions are highly secure, amenable to audit and follow widelyaccepted open standards to ensure eventual inter-operability among the different systems. Need for Integration Recognizing the important role of non-banking finance sector (both corporate and unincorporated) in the credit markets of our economy and collect data to estimate their share to enhance the credit delivery to millions of service entities, the commercial banks can lend to these non-banking institutions that in turn can provide it to the business entities. This would go a long way to reduce the cost of credit delivery at retail levels and facilitate dealing with inflation. Globalising our financial sector without domestic integration of the credit markets may lead to a situation of cherry picking by the global players and /or linkages created only at the creamy layer level without adequate strengthening of the base of the system. The paradigm of taking the UIBs as Channel partners by the commercial banks in a

large scale would facilitate the players in these fastest growing activities to compete effectively with global players in the emerging scenario. The focus should be on development and not just on regulations. It is time the Government and the RBI think of constituting a non-banking developmental and regulatory agency. Of course, we feel regulation should come later than development. The said authority should also have it under its ambit the un-incorporated bodies currently regulated by state governments. The said authority can be under the Ministry or under the RBI till we are on the learning curve. It is required for us to recast the financial architecture of the Indian financial system if it has to ensure growth of the economy along with adequate availability of credit to the fastest growing sectors of the economy. The aggregate monetary policy of the Central banker in taming the inflation can be achieved if and only if the role of non-banking financial institutions including the UIBs are recognized, encouraged and integrated in our financial system.

The only reason a great many American families dont own an elephant is that they have never been offered an elephant for a dollar down and easy weekly payments. Mad Magazine Id like to live as a poor man with lots of money. Pablo Picasso

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