- By Anand Sahasranaman, IFMR Trust

Gram panchayats in India are independent, constitutional bodies of governance that operate at the level closest to the people or the grass-roots. They are constitutionally vested with powers and responsibilities to foster economic development and social justice. The statutory functions of gram panchayats, as defined by the Tamil Nadu Panchayati Raj Institutions (PRI) Act, include the provision and maintenance of public infrastructure for services such as water supply, public hygiene, garbage disposal, roads, street lights and rural housing among others. IFMR Finance Foundation’s ‘Financing Rural Infrastructure’ initiative aims to gain a deeper understanding of gram panchayats, their responsibilities, their financial wherewithal, their ability to attract debt to finance public infrastructure, and use insights gained from these explorations to design financing programs for rural infrastructure provision.

IFMR Finance Foundation conducted an analysis of three villages – Karambayam, Nattuchalai and Alakkudi in Thanjavur district to better gauge the state of public infrastructure in these villages, the financial status of the gram panchayats, their investments in public infrastructure and how these investments have been financed. The initiative also explored alternative funding channels and how these can be exploited to enhance infrastructure development and delivery of services in the three villages.

In order to perform its statutory duties, the PRI act provides for a number of levers of financing that are available to gram panchayats-

• Own revenues – These are taxes and levies like house tax, professional tax and water charges that a gram panchayat is empowered to levy.
• Assigned Revenues – Assigned revenues are revenues directly due to the gram panchayat, but are collected by the state government and remitted to panchayats once every six months.
• Devolved Revenues – Devolved revenues are direct grants from the state governments to panchayats based on the recommendations of the State Finance Commission (SFC). These revenues are transferred to panchayats on a monthly basis.
• Loans – The TN Panchayati Raj Act empowers panchayats to access loans for the purposes of infrastructure development and service delivery. However, it does not appear that any gram panchayat in India has used this power.
• Scheme based financing – Panchayats also have access to funds from central and state government schemes, but these tend to be tied funds that are to be used for a specific purpose. Examples of scheme based (tied) funds include the National Rural Employment Guarantee Scheme (NREGS) and the Indira Avas Yojana (IAY).

IFMR Finance Foundation’s analysis revealed that panchayat incomes are largely dependent on SFC devolutions (up to 80% of overall revenues), which to a large extent are predictable and timely.

All panchayats seem to suffer from poor collections in their own revenues base, especially house tax and water charges. The issues underlying under-collection and non-collection of revenues are manifold- lack of incentive to pay water charges, poor auditing mechanisms, lack of up-to-date housing survey information and the thin structure of panchayat staffing. In addition to these efficiency considerations, there is also the overhanging problem of low tax rates and charges.

On the expenditure front, water supply infrastructure and roads and street light maintenance forms a substantial portion of panchayats’ budgets. One of things to note is that sanitation and waste disposal are major concern areas in all panchayats, but there is no substantial investment in solutions to these problems. Of the three villages, only Alakkudi has a drainage system and even this is an open drainage system that is choked with garbage, rendering it useless. Maintenance of infrastructure assets is an area of grave concern.

Therefore, there is substantial room to improve the performance of panchayats in terms of own revenues generation and collection. The predictability of the devolved revenues, in addition to a well functioning own revenues base, can be a powerful mechanism to drive planned infrastructure provision.

The fundamental set of reforms that is required for the effective functioning of panchayats and that will enable the entry of debt to finance infrastructure are listed below –

(i)    Computerising of financial statements of the panchayat
(ii)    A regular physical survey of houses in the panchayat domain, once every 5 years
(iii)    SFC to recommend upper and lower bounds for house tax rates every five years with all panchayats required to set their own rates within this band
(iv)    The need for a ‘panchayat service’ cadre of officers to improve the capacities of a panchayat.

The initiative also analysed in detail the risks involved in the provision of debt to panchayats: operational, credit and political risks. Local financial institutions that have physical presence in villages are very well placed to mitigate almost all of these risks. This puts them in a position to participate as debt providers to the panchayat in financing local public infrastructure projects.

Using the insights gained from their analysis, IFMR Finance Foundation has come up with a few financing programs which are being piloted currently:

a) Sanitation Finance – provision of a loan from a local financial institution to household for the construction of a toilet. Households can build the toilet and access the grant available to them through the Total Sanitation Campaign. The one-year loan is repaid by the household on a monthly basis

b) Rural Housing Finance – a loan is provided to households who have been chosen under central and state government housing schemes. This loan can be used by clients both a bridge financing to enable them to access the tranches of grants under government schemes (and repay the loan) or as additional financing, that they can use over and above the grants available to them. Households can then repay the loan over three years or choose to pre-pay at any time prior.

These programs are designed to be easily replicable so that they can be taken to scale by rural financial institutions across India.

By Suyash Rai, IFMR Finance Foundation

In what could become a welcome trend, the RBI has started putting out detailed discussion notes on future policy steps. Recently, the central bank released a discussion paper presenting the pros and cons of various approaches to new bank licenses . Though the paper doesn’t clearly favour any particular structure, it does seem to be tilting towards or away from certain possibilities. One possibility that the paper seems to be almost squarely opposed to is of allowing more small banks to be set up in the country. The paper lays out some arguments opposing the idea of small banks, and cites experience with small banks like local area banks and urban cooperative banks to make a case against them.

As far as performance of local area banks is concerned, the record in itself doesn’t prove that the small banks don’t stand a chance. The Indian experience with such banks has been a mixed one, and there are examples of well performing banks in almost every category of small banks (local area banks, district credit cooperative banks, urban cooperative banks, etc), as there are of non-performing ones. This is true for big, national banks as well. This process is inherent to the process of development of institution-types, and the key is to ensure learning and application of “design principles” that make banks successful, rather than writing off entire categories of institutions. If there are indeed inherent weaknesses in the model, which are unmanageable, then the model should very well be discarded. If there are advantages in the model, and weaknesses that can be managed by some structural innovations, then there is no real need to discard the small banks model itself.

Before we consider the challenges to stability and continuity of small banks, and ways of managing these challenges, the key question to ask is: what really are the advantages of small, local banks? Interestingly, the RBI paper cites financial inclusion (i.e. expanding access to financial services) as the main objective for providing more bank licenses. Let’s stay with this objective. Firstly, small banks have proven advantages in processing “soft” information, which is crucial for lending. Professor Jeremy Stein of Harvard University has argued that such institutions are likely to be more successful when information is “soft” and cannot be credibly transmitted. In contrast, large hierarchies perform better when information can be costlessly “hardened” and passed along . There is documented tendency for bank mergers to lead to declines in small-business lending. Studying the empirical evidence on large/multi-national banks, Professor Atif Mian of University of California, Berkeley, shows that greater cultural and geographical distance between a foreign bank’s head quarter and the local branches, leads it to further avoid lending to “informationally difficult” yet fundamentally sound firms requiring relational contracting . Greater distance also makes them less likely to bilaterally renegotiate, and less successful at recovering defaults. The small/domestic banks have been shown to have more smaller/local (profitable) clients. Such differences can be economically large enough to permanently exclude certain sectors of the economy from financing by such large banks.

This ability to process soft, local information is particularly crucial in India, where “hard” information (credit history etc) about a vast majority of people is not readily available. In other words, the main way for banks to know about most clients in India is to access and process local knowledge, mostly captured through local presence, and small banks have proven to be much better at doing this. Big banks tend to skim the surface, where small banks can and usually do go deeper and provide services to many more.

Complete financial inclusion means providing financial services in a high quality, so that people use the services actively. Quality can be understood in terms of the convenience, flexibility and reliability of these services, which are universal terms, but must be defined locally. For example, different timings for bank branch may be deemed convenient in different parts of the country, and this has to be managed on the basis of local understanding. The second big advantage of a small bank is its ability to be agile about local preferences for providing convenience and flexibility required to use banking services effectively. Thirdly, if an institution’s horizontal growth (across geographies) possibilities are limited, it has greater incentives to try harder to grow vertically, by serving more people in the geography and providing more services to the same clients, enhancing the financial inclusion agenda.

Now, let’s consider some of the weaknesses/challenges identified by the RBI discussion paper. According to the paper, the key inherent weaknesses of the small, local area bank model are: a) unviable and uncompetitive cost structures due to small size, b) high concentration risk and higher risk of adverse selection due to geographical concentration, c) limited ability to attract professional staff and competent management due to salary and location constraints, and d) lax governance standards because of concentrated ownership. Though these could be critical challenges to stability and continuity of small banks, there are ways to mitigate most of these weaknesses. For example, the concern about costs is primarily related to the inability of small banks to incur large capital expenditures for deploying systems like core banking systems, or risk management platforms. Innovations in recent times have made it possible to develop and offer these systems Application Service Provider (ASP) form, wherein the user doesn’t need to incur large establishment expenses, but pays on the basis of usage. The software industry is churning out such solutions regularly.

The concentration risk can also be managed if the risk is properly managed by the bank, with systematic risk regularly transferred to entities or markets able and willing to hold the risk for a fee. For example, a local area bank is highly vulnerable to risk of flood in the area, which would lead to a run on the deposits and high defaults on loans. A big part of such systematic risks should be transferred out from the small bank’s balance sheet, while the bank should hold the risks it can manage. This could be done by securitization or parametric insurance on the portfolio, and could be made mandatory by RBI. Also, these banks can be asked to maintain higher capital adequacy. In some cases, the regulator could severely restrict the ways in which the bank can use the savings mobilized. For example, it could make it mandatory to invest most or all of the short-term savings in cash or government securities (narrow banking). Other such solutions could be considered for managing this weakness.

Attracting professional staffs and management is easier if the bank, true to its nature, focuses on recruiting and nurturing local talent. Corporate governance issues can be best addressed by requiring that the ownership is not very concentrated, and the board composition is a healthy mix of independent directors, executives and promoters. Also, oversight of these institutions could be strengthened by regular and close monitoring by investors and lenders to the bank. If the system is made transparent and market-based, the market participants would be incentivised to monitor the institutions and ensure quality, thus adding to the regulation and supervision by the regulator.

The key point is that, if we do acknowledge the important advantages of small banks in meeting the objective of financial inclusion, we can find many ways of addressing the challenges cited in the RBI paper. There are strong reasons to believe that the advantages are substantial enough to find and deploy these solutions.

Interestingly, the issue of optimal size of the banks is being debated internationally, especially in wake of the recent financial crisis, which has once again brought forward questions about the optimal size of banks from the point of view of service quality as well as systemic risk. Emergence of more high quality small banks could create a more fragmented and competitive banking sector, which will also minimize the “too big to fail” threat that much of the world banking sector faces.

This argument for more small banks in no way undermines the importance of other financial institutions. World Bank’s Chief Economist Justin Lin recently wrote a paper arguing that small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage. While his argument for small banks is spot on, he also argued that the size and sophistication of financial institutions and markets in the developed world are not appropriate in emerging markets. This is not necessarily true, because small banks and larger financial institutions/markets complement each other in many ways. While the former have distinct advantages in delivering high quality services at the front-end, the latter are required for managing certain systematic risks at the back-end, providing support to small banks for designing appropriate products, and supplying capital for small banks and large projects.

High quality small banks can carry forward what effectively started in the last round of bank licensing in 1993. From the cohort that started with that round of licensing, the banks that managed to succeed (like ICICI Bank and HDFC Bank) carried the paradigm of banking to the next level, taking it forward from what the then existing banks were doing, thus expanding access to a much larger number of people. They did so with increasingly sophisticated products and higher levels of efficiency. Small banks can take this process to the next stage, picking up from what these banks have done (or are doing), and taking the banking revolution to the next frontiers – the remote, rural areas, and the under-served parts of population in urban areas.

Finance Matters column in The Hindu Business Line – Farzana Najeeb of Advocacy writes the fifth article in the series.

Excerpt:

In the past few weeks with microfinance under public scrutiny, the self-help groups (SHG) channel is being positioned as a cheaper alternative of delivering microfinance compared to MFIs. A close look at the characteristics of the SHG model, its cost structure and interest rates to the ultimate customer shows that its cost is comparable to the MFI model despite a lot of implicit subsidies.

The SHG Bank Linkage Programme (SBLP) has contributed significantly to making credit available to the rural poor, but the true costs and risks inherent in this model need to be better understood. Understanding the SBLP

Under the SBLP, a SHG with 10-20 members (usually women) is formed with the support and guidance of a self-help promoting institution (SHPI). The SHG members are encouraged to make voluntary savings, which is internally lent.

To read the full article click here.

By Natalie Colatosti, Advocacy Team Member, IFMR Finance Foundation

The announcement of National Pension System (NPS) Lite, a pension plan geared towards economically disadvantaged populations, brings hope for much needed money during non-productive years. By offering a pension plan for low-income individuals, the Pension Fund Regulatory and Development Authority (PFRDA) has provided a mechanism by which the elderly poor can smooth consumption at a time in their lives when they typically rely on family members.

PFRDA’s pension plan is accessible and affordable. NPS Lite will be offered through aggregators – such as NGOs, MFIs and NBFCs – that already work with economically disadvantaged communities. The plan makes small individual investments possible by availing group platforms through aggregators. This structure allows for low administrative and transactional costs; thereby facilitating low contribution requirements.

The success of the NPS Lite pension scheme relies heavily on high quality aggregators, and IFMR Finance Foundation (IFF) presented recommendations pertaining to this aspect to PFRDA. Given the important role aggregators play as the interface between customers and NPS architecture, PFRDA has provided regulations addressing multiple aspects of operation. For instance, aggregators must have three or more years of experience working in financial services or commodity development, must adhere to ‘Know Your Customer’ requirements, and are not authorized to collect fees for their services to the customer.

NPS Lite is an important step along the path of total financial inclusion. The scheme offers savings to a population that typically does not have resources for their non-productive years. However, it is imperative that the scheme is well organized and maintained, so that the most deprived populations can reap the benefits of their working years later in life.

For more details on NPS Lite regulation, view the Regulations for Aggregators Under NPS Lite-2010 document.

Business Correspondence (BC) model or the third-party agent banking was launched in 2006 in India, with the intent of increasing the ambit of the formal banking sector. Since its inception in 2006, various banks have promoted the BC model in all corners of the country.

In the rural areas around Bangalore, FINO has partnered with a bank towards the extension of banking services through the BC model. FINO is delivering the BC services through “FINO Fintech Foundation” which is a section 25 company.

Recently members from IFMR Finance foundation (IFF) and IFMR Rural Finance visited the FINO Customer Service Points (CSP) in the area to understand better the working of their BC model and to interact with the FINO CSPs and their clients.  The team visited the Ramanagar and Gulberga blocks near Bangalore along with the respective block-coordinators, and was guided by Mr. Sharan, District coordinator of FINO. The visit enabled us to have deeper insights into the pros and cons of the BC model.

The FINO BC model offers no-frill account services involving savings and withdrawals, few CSPs had also tried selling insurance products on a very small-scale. Each CSP at the client level reports to the Block Coordinator, who is in turn, headed by a District Coordinator. The CSP is a contract employee of FINO Fintech foundation, who is a local resident, and is given a fixed remuneration of Rs 750 plus a commission of 50ps on every transaction irrespective of the amount transacted. These CSPs work an average of 4 hours per day and have this job as either the only source of income or as a part-time business.

On an average each CSP handles around 700-800 clients in her/his service area. Each CSP is provided with a POS machine for transactions and has to deposit an initial amount of Rs 10,000 with FINO Fintech foundation (Rs 5000 for the POS and Rs 5000 for the CSP) as guarantee money. A transaction limit of Rs 5000 is imposed on the CSP and once the limit breaches, the POS machine of the CSP gets blocked. It would then require a visit by the Block Coordinator to collect the cash and unlock the machine to carry out further transactions.

The CSPs, with whom the team interacted, found it difficult to sustain the business, as the income obtained from the present BC model was difficult to cover the costs incurred; the door-to-door services provided by the CSPs added to their cost. Apart from this, only 30-40% of the clients were active which further reduced the commissions for the CSP. However it was feasible for CSPs who ran Kirana stores, as majority of their clients visited the store as part of their daily chores and also made transactions with the CSP; he made fewer door step services than other CSPs who were housewives or working in other companies.

On interactions with the clients, the team could infer that the transaction limits imposed on the CSP was a major hindrance to the clients in utilizing these services efficiently and frequently. Many a times, any client who wants to withdraw or deposit amount that is greater than the limit would have to inform the CSP prior hand, thus it would usually take around three days to complete the transaction, consequently undermining the efficiency of the system.

Currently dealing with a minimal set of services, FINO is looking to widen its base by including NREGA payments and Insurance to ensure the sustainability of the model for all the partners.
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Farzana Najeeb of IFMR Finance Foundation contributed to this post.