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Financial Apartheid

Financial services should be provided on the simple principle of a physician: diagnose the ailment and prescribe the appropriate medicine. Each individual requires a different prescription. Research on the financial needs, habits, and behaviours of poor households has shed light on how they manage their complex financial lives.

MOIN QAZI | New Delhi |

Every year, millions of people around the world transition out of poverty with the help of tools that enable them to build more stable economic lives. At the same time, similar numbers continue to remain trapped in a cycle of poverty they are not able to escape.

Similarly, millions of people are pushed back into poverty as they are unable to cope with unexpected economic pressures. A significant driver of this cycle is financial exclusion. Banking is an essential building block to reach greater prosperity and help build a better system where financial services empower disadvantaged groups. Broader access to financial services can create a path out of poverty.

However, big traditional banks often exclude low-income populations by requiring credit score thresholds or minimum balance requirements or by using historically discriminatory practices that keep this low-income customer away from formal finance. Modern lifestyles are predicated on debt. If you have a stable and reliable income, have a bank account with access to a range of modern financial products, you can manage your debts efficiently. This is what the entire financial system is for.

But debt becomes a lifetime’s trap if you don’t have easy access to those financial products. Contrary to common impression, poor people need and use the same variety of financial services and for the same reasons as wealthier clients: educate their children, improve their homes, cope with unexpected emergencies, protect against hazards, seize business opportunities and build assets. Ironically, the people who lack access to these financial tools are also the people who need them the most.

Poorer people who remain excluded from the financial system are forced to rely on expensive and substandard financial products, raising the risk that they will turn to high-cost sources of credit such as usurious loans. The financially excluded have little to no tools to save, send payments, borrow and insure. This makes it hard for them to prepare for life’s most basic events, let alone unforeseen challenges.

The main problem is not that the poor have nothing to save but rather that they are not profitable customers, so banks and other service providers do not try to reach them. Financial exclusion can be highly oppressive and stifling for talented individuals in low-income communities. They don’t have access to affordable capital for setting up their enterprises.

Financial exclusion often leads to broader social exclusion. People who are financially excluded might not be able to access affordable, adequate, and timely credit; they may struggle to budget and manage money or plan for the unexpected and may not know how to make the most of their money.

Low population density, high transaction costs, the need for small and frequent transactions, adverse social and cultural norms, and regulatory restrictions on savings deposits are major barriers to the sustainable provision of formal financial services in underserved markets.

Financial exclusion has several serious consequences for low-income communities, such as dependency, inability to access benefits due to living exclusively with cash, the impossibility of saving money or access to credit and therefore to buying a house or starting a business, and finally, the inability to improve their situation via financial tools. Thus, financial exclusion imposes large opportunity costs on those who suffer from it the most. When coupled with high transaction costs, information asymmetries, lack of collateral or credit histories, these communities are stuck in a bad equilibrium with no escape.

Financial inclusion addresses and offers solutions to the constraints that exclude people from the financial sector. Access to formal financial services is increasing, but many people in the developing world still do not have savings accounts, and many who have one do not use it. While some people exhibit no demand for accounts, most are excluded because of barriers such as distance, cost, and the paperwork involved. Barriers like lack of financial literacy, policy gaps, irregular incomes, remoteness, and high cost of banking services keep vast sections of the population out of the formal financial market.

Many households may be forced to take on debt or sell assets to remain afloat. Those with access to accumulated savings can maintain consumption levels with consistency and avoid more drastic measures, such as distress sale of assets or agricultural produce when faced with income shocks associated with unexpected events such as natural disasters or health emergencies. The socio-cultural and economic factors that drive financial exclusion are complex, so the solutions must be holistic.

The main demand-side barriers to the provision of financial services are lack of awareness, limited financial literacy, and limited access. The designs of most of the products or services offered by banks or the way they are administered are unsuitable for the poor and further dampen the demand for them. The most intimidating aspect is the hard-to-understand paperwork that uses technical language.

At the same time, a lack of financial literacy can result in people making wrong choices and becoming vulnerable to excessive financial risks. From the supply side, the main barrier is transaction cost. This includes requirements of minimum balances or other thresholds and recurring fees that cannot be met by a large number of people.

Pricing becomes a barrier to usage when its terms do not accommodate the income levels of potential users. Either the prices are simply too high or prices are set and charged in a way that is too inflexible to be affordable. A large number of bank accounts remain underused, making it cost-ineffective for banks to service them. From the credit perspective, the lack of collateral
makes lending to small borrowers costly and risky for banks. Small ticket sizes add to the per-instrument transaction cost.

Furthermore, weaknesses in the legal system make it difficult to extend and enforce contracts. As part of government fiats, banks are forced to meet humongous targets for opening accounts to bring the unbanked population into the fold of the financial system. There is always promise that they would become a source of revenue.

However, many of them remain dormant (accounts without any transactions) and inevitably become economic deadweight. The banks cannot afford to lose money servicing them. Services are sustainable so long as intuitions can cover the cost of their delivery. There has to be a business case for every financial service to remain sustainable. Banks have to perforce levy penalties and ultimately shut these accounts; sending them out of the financial system.

Thus, counter-revolution sets in. In the end, customers are back to where they began their financial journey. Such poorly thought-out policies and programmes demoralise all actors in the ecosystem ~ the customers, bankers, economic observers, media, academics, and NGOs working for the financial empowerment of ordinary citizens.

Moreover, it dissipates the enthusiasm of those who propel the entire effort. Finally, it reinforces the prevailing myth that banks are antipoor. We must all understand the limits of the financial inclusion revolution, and we must make
sure it doesn’t turn into a rough and tumble gold rush that ultimately hurts consumers and financial institutions alike. Banks must be cognizant of the social dimension of financial incusing but sourcing accounts and processing them involves time and costs which pinches revenues.

Financial services should be provided on the simple principle of a physician: diagnose the ailment and prescribe the appropriate medicine. Each individual requires a different prescription. Research on the financial needs, habits, and behaviours of poor households has shed light on how they manage their complex financial lives.

This can aid product design and solutions of financial instruments that can be tailored to their needs. Women in rural areas have limited or no access to information on how to engage with the continuously evolving formal financial space, especially when it is online and digital.

Other demand-side challenges include inadequate investment in client capacity-building, lack of trust in institutions and new digital channels, and the limited availability of smartphones outside the upper-middle-class. Several factors amplify the challenge of connecting with unserved customers: their remote locations, lower education levels, and lack of experience with formal institutions Using insights from behavioral economics, banks can structure products that help customers better manage their finances while simultaneously increasing customer engagement and loyalty.

Behavioural science and behavioural insights must be core to the product design process, from framing terms and conditions to establishing delivery channels to designing a user experience. Despite recognizing that many low-income households are good money managers that want to avoid debt, mainstream providers still identify other providers, such as microlenders, as
more appropriate to serve them even in terms of playing a supporting role to social lending, the banks’ efforts have been found wanting.

Financial inclusion cannot be left in the sole charge of finance specialists. We cannot have a one-sector solution. Financial inclusion can succeed only through the convenient marriage of all five paradigms: finance, technology, consumer protection, literacy, and numeracy. There is a need for convergence among all players in the ecosystem. Every player offers unique strengths. By harnessing these mutually-beneficial strengths ~ from financial players, telecommunications providers, NGOs, and government institutions ~ financial inclusion can be fast-tracked.