The Impact of KGFS in Rural Tamil Nadu: Early Evidence from a Randomised Control Trial


By Santadarshan Sadhu, IFMR Finance Foundation

The Kshetriya Gramin Financial Services (KGFS) model since its inception has focused on providing a range of high quality financial services through its geographically-focused community financial institutions using a customised wealth management approach.

Utilising an experimental approach based on randomised rollout of KGFS branches in Pudhuaaru, Vellaru and Thenaaru in rural Tamil Nadu, an impact evaluation is presently being conducted by researchers from Harvard and Duke University in partnership with the Centre for Microfinance and IFMR Rural Channels to rigorously evaluate the impact of rural bank branch expansion at both the household and village levels. Specifically, this unique evaluation will identify how household financial behavior (including household borrowing, savings, purchase of various financial instruments etc.), livelihood choices, agricultural decision-making, social networks and stress related health outcome are impacted by the provision of comprehensive financial services through a localized financial service provider like KGFS.

Out of 160 proposed study sites, KGFS branches are being rolled out in one half (i.e. the treatment group) while the other half (i.e. the control group) will receive KGFS branches after the completion of the study. The assignment to treatment has been done such that each treatment branch has been matched with a control branch based on a variety of geographic traits mitigating the effects that may result from seasonality or geography rather than the introduction of banking services.

Before the rollout of each KGFS branch, a baseline survey is conducted; in total, the study which will cover approximately 6,800 households in the experimental area including 3,400 households in the treatment group and the remainder 3,400 households from the control group. To date, approximately 1300 households have been surveyed.

Among the baseline households which have already been surveyed, a follow-up survey of 673 households was conducted between October 2011 and January 2012 covering eight treatment branches where Pudhuaaru KGFS (PKGFS) offered financial service starting 2010 and corresponding eight control areas. The data from 673 household in the follow up survey was used to compare the borrowing patterns of the areas served by Pudhuaaru KGFS with the respective control areas without Pudhuaaru KGFS. The findings from this follow up survey as published in a recent policy memo present interesting results on the impact of Pudhuaaru KGFS on the borrowing patterns in the treatment areas as compared to the control areas.

This post presents the main findings that researchers identified in the policy memo.

Impact on the Borrowing from Formal Sources1

Comparison of formal borrowing (from scheduled commercial banks, MFIs, Self Help Groups and credit cooperatives) between treatment and control groups (Figure 1) indicates that the average outstanding amount of formal borrowing per household in areas served by a Pudhuaaru KGFS branch is 38% higher than the areas without a Pudhuaaru KGFS branch. Also, the average number of formal loans outstanding per household in the treatment branches is approximately 20% more than in the control branches (Figure 2). Comparing the average amount of borrowing from formal sources including repaid and outstanding, it seems that the average amount of formal loans repaid by the treatment households was almost twice more than the control household (Rs. 7264 by the treatment households as compared to Rs. 3628 by the control). Data on average number of formal loans repaid in the past year indicates that 28% of households in the treatment area have repaid formal loan as compared to 20% in the control areas. These findings clearly demonstrate that the extent of formal borrowing increased in the branch service areas as compared to the similar areas that do not have a KGFS branch. Thus opening of Pudhuaaru KGFS branches positively impacted households’ borrowing from the formal sources.

Impact on the Borrowing from Informal Sources

Comparison of borrowing from informal sources (Figure 3) which include friends, relative, neighbours, shopkeepers, moneylenders, pawnbrokers, landlords and employers shows that average informal borrowing per household in the treatment branches is significantly lower than the average informal borrowing per household in the control branches. As shown in Figure 3 the average amount of informal outstanding per household in treatment areas is 19% lower as compared to the control areas, while the average amount of informal loans per household including outstanding and repaid is 35% lower in treatment areas as compared to the control areas.

The comparison of total loan outstanding in the treatment and control samples (Figure 4)2 indicates that total amount of borrowing from moneylenders in the treatment areas is 11% lower than in the control areas, while the total amount of borrowing from friends, relatives and neighbours in the treatment areas is 22% lower than in the control areas. The results also show that not only the amount of indebtedness, but also the proportion of households reporting any informal loan outstanding is significantly lower in treatment areas (63% with any informal outstanding) as compared to the control areas (71% with any informal outstanding). So, these findings suggest that the opening of Pudhuaaru KGFS branches has significantly reduced the proportion and amount of households’ indebtedness to moneylenders, friends, relatives and neighbours.

Combining the findings related to formal and informal borrowing, the results provide strong evidence that arrival of Pudhuaaru KGFS branches has significantly shifted households’ dependence from informal sources of loan to formal sources of loan. Thus, the interim results from this impact assessment study clearly demonstrate that geographically-focused community financial institutions like Pudhuaaru KGFS can play very effective role in reducing households’ dependence on informal sources of borrowing by providing effective access to formal sources of finance.

  1. Households were asked to only report loans greater than Rs.2,000 so these estimates are likely to underestimate the total effect on borrowing.
  2. The formal loan in figure 4 excludes SHGs as it is separately categorized in the figure.


Digital Currencies and the Larger Questions they Raise

Digital Money

By Ravi Saraogi, IFMR Investments

Digital currencies have generated substantial curiosity over the last year, particularly post the favourable1 hearing that Bitcoin, a prominent digital currency2, received at the US Capitol hill in November 2013. There is growing interest in trying to understand what digital currencies really are but they are much confused because of the difficulty in placing them squarely in the current monetary setup of ‘fiat’ paper currencies. This leads to most dismissing digital currencies as another ‘geeky innovation’ which will fade post the initial curiosity is over, while some confuse it with an online payment system. This can be quite misleading as digital currencies pose important political economy questions on the control of money supply in a society and are deeply connected to a growing3 school of right wing economic thought called ‘libertarianism.’4 Given the increasing usage of digital currencies and the ideological support5 for them in certain section of economic thought, it would be prudent for monetary authorities and regulators to not dismiss such currencies and meaningfully discuss their implication. In this post, we attempt to provide a context for such a discussion by giving a brief overview on the evolution of money and the ideological support for digital currencies.

Are digital currencies ‘money’ as we commonly understand?

Are digital currencies even ‘money’ in the first place? Money is defined as anything that serves as a general medium of exchange. Digital currencies can be used to discharge all the three purpose of money viz., medium of exchange (growing number of establishments accept digital currencies in trade for goods and service), standard of value (the value of other goods and services and can be expressed in digital currencies) and store of value (digital currencies can be stored and used in the future). Digital currencies should not be confused with an online ‘currency’ which is convertible to a fixed pre-determined value of government legal tender. For instance, the digital currency Bitcoin is not an online architecture for transferring government legal tender from one place to another. Bitcoin is an alternative medium of exchange with its own value which fluctuates with other currencies.


As can be seen in the graph above, the exchange rate of Bitcoins to USD has gyrated wildly since the digital currency gained prominence. The recent volatility in the value of Bitcoins can be traded to events surrounding the shutting of Mt. Gox, a popular Tokyo based Bitcoin exchange6. Thus, even though digital currencies like Bitcoin serve all the three purpose of money, they can emerge as a general medium of exchange only if such currencies gain stability.

Evolution of Money

Money was invented to counter the limitations of the double co-incidence of wants in a barter economy. Over the years, different commodities have been used as money, such as seashells, tea, fur, cattle and even tobacco. The use of metal coins as money can be traced back to Lydians in 700 BC from where it was passed on to the Western civilization through Greeks and Romans. Coins served several useful purposes like being durable, portable and having an intrinsic metal value. As trading grew, coins became popular throughout Europe during the 18th century. These coins, which contained metals, were examples of ‘commodity money’ – where a commodity which had precious value was used as a medium of exchange. Commodity money had both intrinsic as well as exchange value.

The use of paper money can be traced back to the Chinese T’ang Dynasty (618-907 A.D.). Initially paper money could be exchanged for certain commodities like gold, silver or even tobacco7. Such paper money convertible to fixed quantity of certain commodities was termed as ‘representative money’. Again, representative money had both intrinsic value (as they could be converted to certain commodities) as well as exchange value.

The final evolution of money is ‘fiat money8. Fiat money is similar to representative money except it can’t be redeemed for a commodity. The Reserve Bank of India (RBI) notes we use today are an example of fiat money9. Fiat money has only exchange value (which is derived from a government ‘fiat’ or order) and no intrinsic value.


From the above discussion, it is clear that digital currencies are similar to fiat paper money in the sense that they only have exchange value and no intrinsic value. However, the exchange value of digital currencies is completely market determined and is not derived from decree of the government. This is the single most important reason why such currencies are lauded by supporters of the free market, particularly libertarians, who are distrustful of the government’s monopoly role in controlling the money supply10.

Exchange Value of Digital Currencies

Digital currencies derive their exchange value from several characteristics. Such currencies represent a completely decentralized anonymous peer-to-peer medium of exchange. They bypass any regulatory restrictions for cross border transfers as digital currencies do not depend on conventional payment platforms (like Visa, MasterCard) or clearing houses and are transferred electronically. For instance, Bitcoins are electronically transferred from one e-wallet to another e-wallet hosted on personal computers scattered throughout the world. These features make the architecture of digital currencies the most cost-efficient and anonymous way to transfer money from one place to another11. The downside is that this anonymity, regulatory bypass and lack of KYC make them extremely vulnerable to use by anti-social agents. Bitcoins have been used extensively in trading for illegal drugs through an online platform called ‘Silk Road’. The anonymous nature of Bitcoins can also lend itself to financing terrorist activities. There have also been concerns on the security architecture of digital currencies with reports of several heists from Bitcoin e-wallets12.

The fact that digital currencies only have exchange value and no intrinsic value has led many people to say that such currencies represent a bubble, much like the ‘tulip mania.’ This argument however overlooks the fact that by this reasoning, all money are always in a bubble as money (by definition) will always have exchange value over and above its intrinsic value, and in this sense, its value is always inflated compared to its intrinsic value. The caveat here is that while fiat paper currencies are backed by government legal tender laws, there is no corresponding backing for digital currencies from any monetary authority.

Ideological support for Digital Currencies

Digital currencies have several similarities with the classical gold standard system of 1815-1914 when national currencies were convertible to a fixed quantity of gold. Libertarians consider the classical gold standard as the “Golden Age” of unadulterated monetary system13. Prominent libertarians like US Senator Ron Paul, who leads the ‘Audit the Fed’14 campaign in the US and supports a return to the gold standard15, look favourably at digital currencies like Bitcoins because of the similarities. In fact the similarity of the Bitcoin economy to the classical gold standard system has led many libertarians to hail Bitcoin as the free market solution to private currency16. The similarity with gold standard can be clubbed under three broad heads:

Market selection of the medium of exchange

Sympathizers of the gold standard support digital currencies as they derive their exchange value endogenously without any backing by a government or central bank monetary authority. This is much like the emergence of gold as a medium of exchange in competition to other commodities like tobacco, sugar, cattle, tea, shells among others. Among various alternatives, gold was established as the preferred medium of exchange for its acceptability, durability, portability, homogeneity and scarcity. In April 1933, the US went off the gold standard where US citizens could no longer redeem dollars in gold but the foreign central banks could still convert their dollar holdings to gold at the Federal Reserve. In August 1971, President Nixon took US completely off the gold standard by revoking the foreign convertibility of the dollar to gold. For a supporter of the gold standard, the next best bet would be to support a digital currency which mirrors certain gold standard characteristics.

Market determined supply

The supply of money in a gold standard was market determined. The supply of gold would increase as long as the marginal cost of mining gold is less than the value of goods and services which an incremental unit of gold can buy. Thus, a gold mining company would produce gold till arbitrage opportunities have been exhausted through the forces of perfect competition.

The money supply process is similar for digital currencies. For instance, participants in the Bitcoin economy mine the digital currency by solving complex computational algorithms till the time the marginal cost of undertaking this activity exceeds the incremental value of the goods and services which a Bitcoin can buy. The maximum supply of Bitcoin is by design fixed at 21 million coins17, which is similar to a gold standard economy where the stock of gold is fixed.

It should also be noted that the monetary operation of a Bitcoin economy would be exactly the same as under the gold standard where a fixed stock of the money supply finances growing global exchange through divisibility of the unit of currency18. Also, the stock of money supply is immaterial as divisibility ensures adjustment in nominal denominations without changes in real values19.

Competition to Government Legal Tender

As an alternative currency without backing of any legal tender laws, digital currencies circulate in competition to fiat currencies as a medium of exchange. This is along the lines of the libertarian demand for open competition in currencies20.

Regulatory Oversight

The regulatory oversight for digital currencies has not fully developed with monetary authorities around the world adopting a strategy of wait-and-watch. The limited regulatory actions that have been promulgated till now has been sporadic and based on two primary concerns – financing of anti-social activities and evasion of capital controls. In the case of Bitcoins, given its anonymous character, it has been used extensively in trading for illegal drugs through the online platform Silk Road. In October 2013, the FBI seized 144,000 Bitcoins from Ross Ulbricht, the alleged owner of the online platform. At today’s exchange rate, the value of the seized Bitcoins is in excess of USD 70 mn21. By August 2013, the U.S. Department of Homeland Security had seized bank accounts worth USD 5 mn of Mt. Gox as it had failed to register itself as a money transmitting business and was in violation of U.S. anti-money laundering regulations22. More recently, China’s central bank prohibited financial institutions from handling Bitcoin transactions on concerns such digital currency pose on bypassing capital controls23. This was after China had become the world’s largest trader in Bitcoins.

India’s central bank, the Reserve Bank of India (RBI), issued an advisory warning against the risks of dealing in digital currencies like Bitcoins24 on December 24, 2013. Days later, Enforcement Directorate (ED) officials at Ahmedabad raided two companies engaged in Bitcoin transactions25. The concerns highlighted by RBI were susceptibility to hacking26, no dispute settlement mechanism as Bitcoins bypass any authorized central agency, speculative value, unknown legal status of Bitcoin exchange platforms, use in illegal/illicit activities, breach of anti-money laundering (AML) and combating the financing of terrorism (CFT) laws.

Thus, the regulatory oversight for digital currencies has primarily been inspired by concerns on their end-usage and capital controls. None of the regulatory actions taken so far can be explicitly linked to concerns that digital currencies pose on the control over an economy’s money supply by a central bank. This can be justified as the volume of digital currencies is small compared to central bank issued money. However, if the usage of digital currencies grows to materially alter the dynamics of money supply in an economy, central banks around the world will have to think hard on the regulatory landscape for such currencies.


Digital currencies have introduced, albeit small, a competition to government backed legal tender. Though the architecture of digital currencies is still unstable and receives ideological support from only non-mainstream sources, it would not be prudent to underestimate them. Given the important questions that the evolution of digital currencies raise (and Bitcoin is just one among the several27), there is a need to understand this new medium in the context of our regulatory framework in a much more holistic manner.

  1. Mythili Raman, the acting assistant attorney general for the US Department of Justice’s criminal division, said in testimony before the Senate Homeland Security and Government Affairs Committee that, “The Department of Justice recognizes that many virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce.”
  2. There are now in excess of 12 million Bitcoins in circulation with a total market value of close to USD 8 billion
  3. An example would be the rise in prominence of the Tea Party movement in the US. In their study titled ‘Libertarian Roots of the Tea Party’, David Kirby and Emily Ekins argue that “The tea party has strong libertarian roots and is a functionally libertarian influence on the Republican Party”.
  4. David Friedman, in his book ‘The Machinery of Freedom’, says, “The central idea of libertarianism is that people should be permitted to run their own lives as they wish.”
  5. This Washington Post article argues that Bitcoin received “overwhelmingly positive” hearing at the US Congressional meeting due to “months of careful diplomacy by Bitcoin advocates.”
  6. http://www.forbes.com/sites/cameronkeng/2014/02/25/bitcoins-mt-gox-shuts-down-loses-409200000-dollars-recovery-steps-and-taking-your-tax-losses/
  7. For e.g., in 1715 Maryland, North Carolina and Virginia issued tobacco notes which could be converted to fixed quantity of tobacco
  8. Fiat is defined as “an official order given by someone who has power.” Paper money is used as a medium of exchange on the ‘fiat’ (order) of the government
  9. For e.g., a Rs 20 note (or for that matter any other rupee denomination note) is signed by the RBI Governor as “I promise to pay the bearer the sum of twenty rupees”
  10. Thomas Woods, a prominent contemporary libertarian writes in detail about this in his paper titled ‘Why The Greenbackers are Wrong’ at http://tomwoods.com/blog/why-the-greenbackers-are-wrong/
  11. The recent Department of Justice hearing on Bitcoin in the US emphasized that virtual currencies like Bitcoins “have the potential to promote more efficient global commerce.” http://www.theguardian.com/technology/2013/nov/18/bitcoin-risks-rewards-senate-hearing-virtual-currency
  12. http://www.technologyreview.com/news/522411/bitcoins-rise-constrained-by-heists-and-lost-fortunes/
  13. See Rothbard, Murray (1963), ‘What has Government Done to our Money’, Section IV, Ch. 1, p86
  14. The Federal Reserve Transparency Act, a bill to audit the Federal Reserve, was introduced by Ron Paul in February 2009
  15. Ron Paul has been a strong advocate of the gold standard. See Paul, Ron (1981), “Gold, Peace and Prosperity: The Birth of a New Currency”, Mises Institute
  16. For e.g., the Libertarian Party in the US accepts contribution in Bitcoins on its website http://www.lp.org/make-a-bitcoin-contribution
  17. For an exhaustive FAQ on Bitcoins, see http://bitcoin.org/en/faq
  18. While Bitcoins are divisible to 0.00000001 units, paper receipts backed by gold (which were the predominant operational system for the gold standard) were also divisible to small denominations.
  19. The easiest way to think about this under a fiat money economy would be to assume that one morning you are told that an extra ‘zero’ has been added to all monetary denominations. So Rs 10 is now Rs 100. What used to cost Rs 10 before will now cost Rs 100. Similarly, if you were earning Rs 10 before, you will now earn Rs 100. In real terms, nothing changes. By adding an extra zero, we have increased the monetary base in an economy ten times without any change in real values. Thus, neither does the initial stock of money nor the total money stock has any bearing on a Bitcoin or gold standard economy.
  20. US Senator Ron Paul, a prominent libertarian, is the sponsor of the Free Competition in Currency Act of 2011, which seeks to repeal legal tender laws backing government issued currencies
  21. http://www.forbes.com/sites/andygreenberg/2013/10/25/fbi-says-its-seized-20-million-in-bitcoins-from-ross-ulbricht-alleged-owner-of-silk-road/
  22. http://techcrunch.com/2013/08/23/feds-seize-another-2-1-million-from-mt-gox-adding-up-to-5-million/
  23. http://www.bloomberg.com/news/2013-12-05/china-s-pboc-bans-financial-companies-from-bitcoin-transactions.html
  24. http://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30247
  25. http://articles.economictimes.indiatimes.com/2013-12-27/news/45626789_1_one-bitcoin-bitcoin-transactions-peer-to-peer-payment-network
  26. There have been several media reports of hackers breaking into electronic wallets and wiping out balances of digital currencies like Bitcoins and Dodgecoin
  27. Some others are Litecoin, Namecoin, Peercoin, etc. For a full list, see http://www.theguardian.com/technology/2013/nov/28/bitcoin-alternatives-future-currency-investments


Towards a Suitability-based Customer Protection Regime in India

This post is part of IFMR Finance Foundation’s blog series on the CCFS Report.

By Vishnu Prasad, IFMR Finance Foundation

The current regulatory approach to customer protection in India can be divided into two complementary ex-ante approaches- mandated information disclosure, and financial literacy and education. Both approaches, predicated on the principle of ‘buyer beware’, seek to improve the decision-making ability of the consumer by reducing the information asymmetry between the buyer and the seller. However, recent studies find that these approaches do not adequately protect the customer. For example, customers are often ‘over-loaded’ with information by disclosure documents and this leads them to take sub-optimal decisions1. Evidence also suggests that firms do not use these measures to act in the best interest of the customer. For example, in the Indian mutual fund context, studies have shown that firms respond to disclosure policy relating to un-shrouding of fees by altering products to essentially maintain lack of clarity in pricing2. Evidence also points to the weak relationship between financial literacy and financial behaviour. For example, a recent meta-analysis of 168 papers that study the relationship between financial literacy and financial behaviour finds that interventions to improve financial literacy explain only 0.1 per cent of the variance in financial behaviours studied, with weaker effects in low-income samples3. When the fact is considered that asymmetry in information, expertise, and power between the buyer and seller of financial products will only be exacerbated in the future, it becomes clear that existing approaches cannot underpin the customer protection regime in India.

The report of the Committee on Comprehensive Financial Services (CCFS) argues that India needs to move to a customer protection regime where providers need to be held accountable for the service to the buyer. Taking the lead from the FSLRC, the CCFS Report envisions that each low-income household and small-business would have a legally protected right to be offered only suitable financial services. The Committee recommends that the RBI should issue regulations on Suitability, applicable specifically for individuals and small businesses, to all regulated entities within its purview. These regulations should be applicable specifically for individuals and small businesses defined under the term ‘retail customer’ by the FSLRC4.


As described in the table above, the notion of Suitability should be viewed as a process followed by the provider rather than as a guaranteed outcome for the customer. Suitability as a process requires every financial services provider to have a Board approved Suitability Policy that the company must follow in all interactions with customers and it will be the implementation of the Suitability process that will determine if a financial services provider has indeed acted in the best interests of the customer. Global financial customer protection regimes in Australia, UK, and USA have shifted to a provider-liability regime and mandated a process for ensuring Suitability. For example, in the case of a standard home loan product, regulators in these countries require that Suitability assessment take into account three parameters:

a. Customer’s requirements and objectives: The Australian Suitability assessment mandates that the financial services provider look into several aspects of the customer’s requirements and objectives including the purpose for which the credit or customer lease is sought, the nature of the credit requested by the customer, and the customer’s understanding of the proposed contract.

b. Financial Situation of the customer: CFPB regulations in the USA require that monthly payments be calculated based on the highest payment that will apply in the first five years of the loan and that the customer have a total debt-to-income ratio that is less than or equal to 43 per cent.

c. Other parameters: Certain regulations like the US guidelines deem specific characteristics of a home loan product (like loans with negative amortisation, interest-only payments, balloon payments, terms exceeding 30 years and the so-called no-doc loans) to be “globally unsuitable” for all categories of customers.

Suitability is by no means a new concept in India. For example, the RBI itself has issued Suitability and Appropriateness guidelines for derivative products. These guidelines mandate that market-makers should undertake derivative transactions, particularly with users with a sense of responsibility and circumspection that would avoid, among other things, mis-selling. SEBI’s Investment Advisers Regulations, 2013 mandate that the investment advice provided should be appropriate to the risk profile of the client and that the structure and risk reward profile of the recommended product should be consistent with client’s experience, knowledge, investment objectives, risk appetite and capacity for absorbing loss.

The CCFS also endorses the creation of a unified Financial Redress Agency (FRA) as a unified agency for customer grievance redress across all financial products and services. This Agency is envisaged to be consumer facing and will in turn coordinate with the respective regulator for customer redress. This way, the consumer will not be expected to understand regulatory architecture to lodge a grievance.

Furthermore, the report recommends a citizen-led approach to surveillance and monitoring. The report provides the example of the Economic Offenses Wing (EOW) of the Tamil Nadu Police Department which has engaged members of the public to monitor non-banking financial institutions in the state. Taking a lead from this, the Committee recommends that RBI should create a system by which any customer can effortlessly check whether a financial firm is registered with or regulated by RBI. Customers should be able to access this service by phone, through SMS or on the internet.

  1. See: Spindler, Gerald. “Behavioural Finance and Investor Protection Regulations.” Journal of Consumer Policy 34, no. 3 (2011): 315-336.
  2. See: Anagol, Santosh, and Hugh Hoikwang Kim. 2012. “The Impact of Shrouded Fees: Evidence from a Natural Experiment in the Indian Mutual Funds Market.” American Economic Review, 102(1): 576-93
  3. See: Fernandes, Daniel, John G. Lynch, and Richard G. Netemeyer. “Financial Literacy, Financial Education and Downstream Financial Behaviors.” Management Science (2013).
  4. FSLRC defines a retail customer as “an individual or an eligible enterprise, if the value of the financial product or service does not exceed the limit specified by the regulator in relation to that product or service.” Further, an eligible enterprise is defined as “an enterprise that has less than a specified level of net asset value or has less than a specified level of turnover.”


A greater role for Development Finance Institutions

By Deepti George, IFMR Finance Foundation

The Committee on Comprehensive Financial Services for Small Businesses and Low Income Households (CCFS) seeks the creation of an ecosystem of different types of institutions, each with their choice of specialisation such that there would be multiple partnerships between these specialists. It states that increasingly, each bank will need to become inherently stronger, focus more sharply on their core capabilities, and have the flexibility and the regulatory mandate to collaborate actively with other market participants who have complementary capabilities instead of being forced to follow identical strategies as every other participant. The CCFS report covers a set of recommendations that pertain to the role for Development Finance Institutions (DFIs) such as NABARD, SIDBI, NHB and CGTMSE in making this a reality.

1. Market Making and provision of risk-based credit enhancements

CCFS sees the role of DFIs to be one that moves away from being institution-specific providers of automatic finance/refinance, to one of market making – that facilitates the orderly development of the sector, strengthening the better institutions while allowing weaker institutions to gradually fade away. DFIs could become providers of second loss deficiency guarantees and credit enhancements as well as facilitate listing of debt securities for institutions. Such a market making function would enable institutions serving rural and agriculture sectors to bring down their cost of capital and access easier and cheaper funds from the market, thereby attracting stronger players and investors into the sector. Such facilities must be priced based on underlying risks and must be neutral in its choice of eligible institutions. In other words, such facilities are to be extended based on the nature of the activity of the end borrower and not to be based on the type of institution that can avail the benefit.

The idea of a market maker is not a novel one and DFIs such as NHB and SIDBI play this role. Another example of such an institution from the USA is the Federal Agricultural Mortgage Corporation or Farmer Mac1. It was created in 1971 as a statutory body to establish a secondary market by providing securitisation and guarantee services for agricultural real estate and rural housing mortgage loans, rural utility loans and loans guaranteed by the US Department of Agriculture2. As on December 31, 2012, total outstanding amount of eligible loans across all its lines of business amounted to $ 13 billion.

To fulfil the role of a market maker, there is a need for DFIs to shift to Risk- based mechanisms in both market making and supervisory functions. These mechanisms would entail graduating to risk-based pricing of all facilities that the DFI chooses to provide, such as refinance and guarantees, as well as of deposit insurance for supervised banks by the DICGC. To make this possible, there needs to be an environment where a picture that is closest to accurate is available on each of these entities in a high frequency manner. CCFS recommends that, given the absence of public information regarding the quality of these participants, these institutions be required to undergo rating exercises by commercial ratings agencies and make available to the public the results, especially in the case of Regional Banks. This will help signal to the market who the well-performing institutions are, and help put an end to any discrimination they may have been facing so far, as well as push bad-performers to either improve or to cease operations.

2. Management of Systematic Risks

CCFS acknowledges that Regional Banks such as cooperative banks are much better placed than large national level banks in agriculture credit delivery. Their local presence and deposit-taking capabilities permanently anchor them to the community giving them both the desire and the requirement to stay connected to the local community during both good times and bad ones. However, this also gives such institutions an inability to successfully manage regional level systematic risks such as rainfall shocks and local-economy related events such as commodity price fluctuations which have adverse effects on asset quality. The fear that local deposits used to fund the loan portfolio would get eroded due to these risks is a legitimate one. This fear is further exacerbated by the requirement for the loan portfolio to be necessarily held to maturity and the non-availability of risk transfer markets where those risks that cannot be managed locally can be transmitted to large national level institutions that are well-placed to hold them.

The CCFS report cites the example of Germany as a possible approach towards active risk management for Cooperative Banks. It covers the German Sparkassen Banks3 which are small banks each serving their respective region and function to provide bank accounts and loans and other financial services for the local community. These are not profit oriented and are part of a national system that spreads risk across a system of Regional Banks and national institutions which include the “Joint Liability Scheme” of national and regional guarantee schemes coordinated by the Deutscher Sparkassen und Giroverband (DSGV: the German Savings Bank Association). Germany also has credit guarantee banks that lend within each federal region or Land organised through the Verband Deutscher Bürgschaftsbanken (VDB: the Association of German Guarantee Banks). They are non-profit associations of lenders that historically provided sureties worth 80% of the loan value. Each guarantee bank would take on up to 35% of the risk, while the federal government took 40% and the Land 25%. The borrower pays a fee of 1-1.5% of the loan plus an annual commission of 1-1.5% on the amount outstanding each year. Historically borrowers were at risk for 20% of the loan value, but as a result of the recent financial crash the German Government has encouraged guarantee banks to cover 90% of the risk and to take up to 50% themselves. The absence of such a superstructure that cooperative institutions become part of and which guarantees some form of portfolio protection in the wake of an adverse event may be one important reason for the decline in market share of community banks in the USA4.

A body similar to the German VDB could be created by NABARD for all Regional Banks, to provide guarantees for a significant portion of the portfolio of cooperative banks and thus to help tide over losses due to systematic risk events that Cooperative banks are more prone to facing given their local nature.

Another alternative that DFIs have is to facilitate creation of active securitisation markets for the transfer of systematic risks (that these regional institutions are poorly equipped to hold) to large national-level aggregators. This is especially with regard to priority sector lending where Regional Banks (with respect to Direct Agriculture), as well as other entities such as NBFCs are very significant net originators of priority sector assets for which there is a proven demand from commercial banks.

  1. www.farmermac.com
  2. Its main secondary market activities pertain to :
    • Purchasing eligible loans directly from lenders,
    • Providing advances against eligible loans by purchasing obligations secured by these loans,
    • Securitising assets and guaranteeing the payment of principal and interest on the resulting securities that represent interests in or obligations secured by pools of eligible loans, and
    • Issuing long-term stand-by purchase commitments for eligible loans
  3. “German Savings Banks and Swiss Cantonal Banks, Lessons for the UK”, written by Stephen L. Clarke, December 2010. Source: http://civitas.org.uk/pdf/SavingsBanks2010.pdf
  4. In the period from 1984 to 2011 the share of US banking assets held by community banks declined from 38% to 14%. Quoted in the CCFS Report from the FDIC Community Banking Study, December 2012


Building a Ubiquitous Electronic Payments Network and Universal Access to Savings – Part II

By Rachit Khaitan, IFMR Finance Foundation

Continuing from an earlier post, this post highlights the CCFS recommendations around various bank and non-bank channels that will serve to deliver a ubiquitous payments network and universal access to savings.

Payments Bank

With the pressing need to provide access to payment services and deposit products to millions of households, the Committee on Comprehensive Finance Services for Small Businesses and Low Income Households (CCFS) recommends that a set of banks may be licensed under the existing Banking Regulation Act, which may be referred to as Payments Banks. These would have the following key features adhering to the Committee’s principle of regulation neutrality:


This differentiated banking design is functionally equivalent to that of the 27 currently existing pre-paid instrument operators (PPIs). While PPIs have enabled significant expansion of low-value payment services, there are several issues around them such as relaxed KYC norms, restricted cash-out facility, inability to pay interest on deposits, and the risk of contagion when partnered with a sponsor bank. Given these difficulties being faced by PPIs and the underlying prudential concerns associated with this model, the existing and new PPI applicants should instead be required to apply for a Payments Bank licence, as described below, or become Business Correspondents. No additional PPI licences should be granted.

The Payments Bank model is based on the premise that there is demonstrated customer preference for a combination of differentiated channels to access payments and credit. A customer would often access payments through a 24X7 ATM whether or not owned by her bank branch or via a credit card POS terminal at a merchant location while for credit, they would be happy to go to have their application evaluated at a more central location. Furthermore, customers often will seek payment and deposit services from one provider while borrowing from another provider.

The Committee envisions a transactions-based revenue model for Payments Banks to ensure financial viability. Payments Banks could also benefit from the shared infrastructure of their existing businesses (such as the sale of mobile airtime or postal products) and enhanced revenue from the additional loyalty induced by the payments business. Discussions with existing PPIs suggest that the market will be extremely competitive with participation from large and small players alike.

In order to address the potential conflict of interest mobile phone companies may face as independent Payments Banks while serving their partner banks, the Committee recommends that the RBI to work with Telecom Regulatory Authority of India (TRAI) to ensure that such companies, including those with Payments Bank subsidiaries, be mandated to:

  1. Provide USSD connectivity as per recent TRAI regulations with the price cap of Rs. 1.5 per 5 interactive sessions
  2. Categorise all SMSs related to banking and financial transactions as Priority SMS services with reasonable rates and to be made available to the banking system.

Business Correspondents (BCs)

This is a powerful channel that banks use to extend the reach of their branches through the use of agents, thereby increasing outreach at a low cost. However, there are specific regulatory barriers that are preventing the effective utilisation of this channel:

  1. ND-NBFCs as BCs: The Committee recommends the restoration of the permission of ND-NBFCs to act as BCs of a bank. The potential conflict of interest associated with NBFCs as a lending channel comingling deposits raised through its BC activity can be addressed by the adequate technology solutions available for intra-day reconciliations.
  2. Distance criteria between the BC and nearest branch: The Committee is of the view that the extant distance criteria (30 km for rural and 5 km for urban) between the BC and a branch of the sponsor bank be eliminated. Banks should be allowed to decide the cash management and operational oversight required.

White-Label BCs

The existing BC channel must be enabled to grow, and one way to enable this is by allowing high-quality, independent White-Label BC Network Operators to emerge which can also increase penetration of payment points in the country. This has already happened in the context of ATMs (White-Label ATMs) and there is a similar objective of loosening the tight coupling between the BC and a sponsor bank by allowing the BC greater operational flexibility as well as more degrees of freedom in determining charges to customers.

White-Label BCs should be fully inter-operable, have the ability to work with multiple banks at the back-end, and have direct access to settlements systems subject to prudential conditions to mitigate operations risk. Potential candidates for such a license could include NBFCs, existing corporate BCs, mobile phone companies, consumer goods companies, the post office system, and real sector cooperatives.

White-Label ATMs

The Committee recommends that White-Label ATMs (WL-ATMs), a recently permitted innovation of independent payment network operators, be given direct access to the payments and settlements system, subject to certain prudential conditions which mitigate operations risk. The current “nested” design, which requires a sponsor bank at the back-end, is fraught with contagion risk especially in the event that the WL-ATM grows very large compared to the sponsor bank.