Customising financial services

– By Shilpa Sathe and Deepti George, IFMR Rural Finance

In the series ‘Finance Matters’, we have examined the various elements that enable the provision of high-quality financial services, particularly for the under-served segments of the population. In this column (the last in this series), we summarise this thinking and paint a vision for the future of financial service access for households.

The current financial system takes a product-menu driven approach, where different providers meet different household requirements such as savings, insurance, credit, pension and payments on a piecemeal basis. The customer takes responsibility for the ultimate outcome, which could be achieving a target annuity during retirement, building the required corpus for a child’s education, or being protected for the full value of human capital.

Today, the disaggregated delivery of financial services has put the onus of taking technically complex financial decisions on the consumer. Even for the highly educated individual, this task has become difficult, if not impossible, given the rapid innovation in the financial marketplace, coupled with limited ability to assess alternatives. Even with easy availability of information, the principal-agent problem remains, with the agent or advisor having limited liability for what she sells.

We have argued in this series that a household needs providers who can offer integrated solutions in a continuous and convenient manner. There is adequate research to show that the financial needs of households are multi-dimensional and one must look to solutions that can necessarily deliver on comprehensiveness. The starting point is a customised financial plan, based on a clear assessment of a household’s financial goals, current and expected cash-flows, appetite for risk, and so on. Specific products are a means to achieve household goals, and not ends in themselves.

Customised plan

This additional responsibility of computation and advice means that the provider will have to take on a more holistic approach, cutting across traditional barriers of institutions and products. Future financial services providers will be akin to general physicians, who bear great responsibility for the health of their patients.

Such a prescriptive approach would also minimise instances of unsuitable advice, such as selling illiquid assets to clients with immediate liquidity requirements, or selling loans that require repayments that do not match the household’s cash-flows.

In such a regime, incentives need to move away from standalone product sale to following a set of protocols that will subsequently enhance the financial well-being of the households served. Such well-being is the state in which a household can optimally choose patterns of consumption over time and in uncertain states of the world.

To choose these patterns of consumption, households should have the ability to grow, manage liquidity and overcome financial shocks, across different periods of time. The integrated approach will equip households with the means to achieve this.

Structural models will have to evolve to incorporate market imperfections such as irrational behaviour, which will necessitate a greater investment in the development of intelligent systems and training resources to deliver high-quality solutions.

Provider’s liability

While developing provider expertise will aid better choice, this approach also calls for extending a provider’s liability to following protocols that are consistent with financial well-being, and for this to be enforceable as a statutory obligation, rather than just a fiduciary one.

This is particularly important because, unlike physical products, financial products lack visibility and, unlike many services, they reveal their real outcomes at a point in time beyond the time of purchase. Clients thus have limited ability to assess upfront, the quality of a product.

This is clearly problematic and highlights the need for ex-post liability regimes in the context of financial service providers. One way this could be addressed is by setting ‘negligence standards’, similar to those in place for consumer products. Customer protection regulation that is currently at a very nascent stage in India will have to evolve to meet these challenges.

The evolution of this fundamentally different approach to product design and delivery stresses the need for functional regulation — that is not product- or institution-based but based on functions served by them. Regulators and policy-makers have a key role to play in aligning the incentives of agencies in the financial market place.

Business model innovation must be encouraged to discover new and integrated approaches to financial services delivery. As discussed earlier, the optimal role of Government is in creating infrastructure — connectivity, unique identity and payment backbone — that will enable all service providers to reduce their cost of operations. Moving ahead, we see no trade-off between ubiquity and quality of services in financial services delivery. Both are achievable.

In summary, a well-functioning financial system should aid transfer of resources across time and different states of the world, helping individuals and organisations manage risk, disseminate price information and align incentives. This is best achieved through the provision of integrated solutions by well-trained providers and requires reliable financial institutions that work towards maximising the financial well-being of clients. Institutional structures and product innovations will need to move together to ensure that the true transformative power of finance is realised.

This article first appeared in The Hindu Business Line


Simple products not always best

By Shweta Aggarwal & Shilpa Sathe, IFMR Rural Finance

A common refrain that one hears in the context of financial services for low-income households is the importance of “keeping it simple”. A simple product, combined with “financial literacy”, is the most common prescription for financial inclusion. But this is a dangerous approach and one that is not rooted in a good understanding of the nature of finance.

Let’s first see how simplicity can affect financial design in the case of a farmer. Before the sowing season, the farmer needs to finance his sowing operations. This can be done in two ways: first, a crop loan payable in equal monthly instalments and second, a crop loan where principal and interest payments are linked to the amount of rainfall obtained in the region.

The first option is clearly a simple product to design and communicate for a provider, since it shifts to the farmer the responsibility of insuring against rainfall risk. The damaging effect of this “simple” loan product is evident, as fixed payments are attached to volatile cash-flows.

The second option, however, requires the provider to develop an integrated solution by hedging the risk at his level. While the resulting product is complex, it addresses the farmer’s needs more efficiently.

Difficult choices

Re-examining this notion of simplicity in the context of retirement planning, we find a household with earning members today wants to invest in assets that will give them stable income post-retirement and protect them from longevity and health risk. An optimal choice here is a contract combining an annuity scheme with health insurance. But, in the market, these are two stand-alone products, priced with very different assumptions.

A health insurance contract assumes that the people who purchase it will be those who expect to fall ill more often; the logic that goes into pricing an annuity, on the other hand, is just the reverse. In this disaggregated method of delivery, purchasing these products individually would not only impose a high cost on the consumer, but will also assume that the average consumer has the capability to understand this contract.

Financial literacy

Policy-makers see financial literacy as a solution to empower consumers and enable them to take decisions that will benefit them. But in the case highlighted above, the expertise needed to choose the optimal bundle of products goes beyond financial training. The financial marketplace is dynamic and it is almost impossible, even for the sophisticated consumer, to keep pace with financial innovation. Even for a well-informed consumer, translation of such knowledge into a purchase decision calls for his getting past an array of cognitive biases, such as procrastination, regret and loss-aversion, mental accounting and information overload. Financial literacy makes the very troubling assumption that if customers had all the necessary information, they would make perfect, welfare-enhancing decisions. Unfortunately, there is very little evidence to back this assumption.

A study conducted by professors at the London School of Economics, and published by Financial Services Authority, shows that behavioural biases often result in sub-optimal decisions for consumers. For instance, lower rates of annuitisation among retirees are attributed to a greater weight being assigned to the risk of early death over a longer-than-expected retirement period.

The inherent difficulty in navigating the growing assortment of choices results in customers placing higher levels of trust in their financial service providers and advisors. However, how much liability does the provider have today for this ‘advice’ that he gives?

Benefits for agents

The model of delivery is largely commission-based, with mutual funds and insurance schemes being pushed on to clients in a way that maximises the agent’s commission and not always the clients’ welfare. Disclosure is usually in the form of a bulky document that the client has to sign on, often a poor substitute for informed consent. Outcomes from an investment are not always possible to predict ex-ante and, in many cases, will depend on the provider’s decisions.

Speculation by a fund manager can, for example, lead to losses for the investor, without the company taking responsibility for it. Risks and losses may not be appropriately conveyed, or conveyed late, leaving the investor to deal with them. Alternatively, the right combination may be technically too complex for the investor to choose by himself. Financial literacy has a very limited role to play here. Is it fair, then, to say that the preoccupation with simplification gives the provider an unfair advantage? Households and individuals are looking to fulfil certain basic functions over their lifetime, such as reducing risks and accumulating assets. These functions may vary at different stages of the life-cycle, as does their capability to achieve them.

An inclusive financial system should be able to equip a household with the right set of tools to enable informed decision-making. While this requires basic knowledge on the part of the consumer, the optimal choice can result only with changes in the current system of product design and delivery. The provider will have to cut across traditional institutional barriers to develop integrated products and services that lead to more efficient financial outcomes. In order to facilitate this process of financial re-engineering regulators and policy-makers will need to work in a coordinated manner. The way forward will be a shift in responsibility from the user to the provider, through a more prescriptive approach to financial service delivery.

This article first appeared in The Hindu Business Line.


Challenge of financing SMEs

– By Arun Kumar D, IFMR Rural Finance

India is home to about 26 million small enterprises (with investments less than 50 million) that account for about 20 per cent of the country’s GDP . While small enterprises drive economic growth with their ability to innovate and employ in large numbers, the biggest challenge faced by them is access to finance.

Small enterprises, such as brick-kilns, grocery stores and small restaurants, need finance to purchase raw materials, procure stock, pay wages, meet other working capital requirements and support expansion plans.

Despite the efforts of Ministry of Small and Medium Enterprises, SIDBI and support from the RBI by inclusion under priority sector, there continues to be a huge demand-supply mismatch in small enterprise financing.

One of the major reasons for banks/financial institutions (FIs) being unable to bridge this gap is the perceived credit risk involved in financing small enterprises. This is primarily on account of non-availability of valid bills, proper accounting systems and lack of known buyers.

To mitigate such credit risk, banks typically look for enhanced collateral or traditional equity, both of which cannot be brought in by most entrepreneurs. Further, due to their small size and local presence, the transaction costs involved in financing them are very high.


In the face of banks’/FIs’ reluctance to lend, these enterprises are compelled to resort to high cost, non-continuous financing from money lenders and other informal sources, or continue to operate at sub-scale. Banks charge an interest rate of 10-20 per cent, compared with 36-70 per cent from informal sources like money lenders. Risks faced by any business can be broadly classified as idiosyncratic or systemic. Idiosyncratic risks are specific to an enterprise, like location of business or skill of the entrepreneur.

Systemic risks, on the other hand, are beyond the control of any enterprise. Such risks make up the environment in which a business operates. Risks due to change in preference of customers, a catastrophic event, and changes in economy are all examples of systemic risks.

The key to financing any enterprise lies in the ability of the financier to evaluate and manage such business risks. High quality origination can help evaluate idiosyncratic risks well. Traditional equity acts as a cushion for such risks. A high quality local originator with geography and business specific information about such enterprises in the operational area will be able to evaluate and manage this risk well and will demand lesser traditional equity to be brought in by entrepreneurs.

Systemic risks, however, are a different ball game. No amount of traditional equity is sufficient when the financier is uncertain about an enterprise selling anything at all in an environment where demand patterns and economic situations can change very quickly.

A financier searches for cues to establish that the business has a current and future ability to service loans, even in an uncertain business environment. For small enterprises that have large number of cash transactions, poor record of sales, produce undifferentiated goods and lack known clients, assessment of systemic risk becomes very difficult.

Such challenges can be addressed through structures that allow financiers to trap cash flows, or by resorting to a stronger and well established sales pattern in a supply chain.


Some ways of financing small enterprises are as follows: Supply-chain financing, where a supplier and a buyer with known balance sheets can be financed.

For example, small enterprises that manufacture and supply jam to large players can be financed if their cash flows are trapped through bills, or by obtaining a collateral/guarantee/comfort letter from the company to which it supplies.

This can be adopted by many financial intermediaries, even large banks. The method has its limits because it requires careful mapping of supply chains. Lending through a local financial intermediary who can verify cash flows and income of the enterprise and finance them through relationship-based approach is another option.

A local financial intermediary who understands the working capital cycle, seasonality, procurement place and mode, point of sales, and demand for the product or service, can finance small enterprises based on an understanding of the geography in general and various aspects of the business in particular.

A local intermediary can ascertain turnover, income and other key financial information required to arrive at a credit decision about the enterprise.

Business-specific templates can be developed for each small enterprise and a master limit can be fixed taking into consideration the scale of business, projected sales turnover and surplus they would generate.

Depending on business requirements, FIs can provide working capital loans, term loans or both. Also, long-term, relationship-based lending helps mitigate credit risk by creating dynamic incentives for the enterprise to maintain a relationship with FIs.


Innovation in product structuring is as important in addressing gaps in small enterprise financing as the channel itself. Innovative products such as equipment lease finance can help address the need for term debt, and products such as receivable financing, bills discounting and factoring could substitute requirements of working capital finance, addressing the unique needs of small enterprises.

Local originators are best placed to do this given their monitoring capability and knowledge of small enterprises, allowing structuring of products like working capital finance, channel finance and cash credits that meet needs of the enterprise, enabling scale.

This article first appeared in The Hindu Business Line


No money to govern rural India

By Anand Sahasranaman, IFMR Finance Foundation

In India, gram panchayats (GPs) were given constitutional legitimacy following the passage of the 73rd Constitutional Amendment Act, which was meant to decentralise power and responsibility to them to improve local public service delivery and governance. Following this, all State governments passed their own enabling Acts, detailing the specific functions and financing powers of panchayats in their jurisdiction, apart from outlining the financing mechanisms available to them, and mandating the provision of public infrastructure services such as water supply, sanitation, housing and roads.

It is almost two decades since these Acts have come into force in all Indian States, but the promise held out by decentralisation, including financing local development efforts, remains unfulfilled.

State of Infrastructure

The state of infrastructure in India’s villages is appalling: 10 per cent of rural population has no access to drinking water; public water supply, where available, largely suffers from bacterial and chemical contamination; in 90 per cent of the villages, there are no sanitation facilities; over 50 per cent are not connected to the power grid; and the average distance to an all-weather road is 2 km. These stark statistics not only point to sharp deficiencies in rural infrastructure, but also highlight the inability of gram panchayats to deliver on their statutory duties.

Why is public service delivery by the panchayats so poor? To answer this, it is essential to analyse funding sources and financial mechanisms available to them. Their finances come from two sources: (i) funds devolved by State governments under the guidance of State Finance Commissions (SFCs), set up every five years and (ii) ‘own’ revenues generated locally from levies of house tax, professional tax and water charges.

Gram panchayats are in a sub-optimal revenue situation by being dependent on fund devolutions from higher-level governments without tapping the potential of their own revenue flows: 75-90 per cent of total revenues are from State government devolutions (grants), and only the rest is generated through local levies. This points to the need for the panchayats to boost their own revenue sources and explore other financing mechanisms rather than depend on State-devolved funds.

Two fundamental issues explain low own revenue generation by gram panchayats: (i) they are reluctant to set tax rates at levels that meaningfully reflect the cost of service provision; they set very low rates and are also reluctant to revise them periodically. Consequently, these levies generate much lower revenues than potentially possible and (ii) the collection efficiencies are substantially low.

Therefore, the panchayats are stuck in a low-level equilibrium, where revenues are compromised by low tax and fee rate regimes and under-collections. Setting reasonable tax and fee rates, improving collection efficiencies and expanding financing mechanisms are central to ensuring buoyancy of GP revenues overtime.

State governments can play a catalytic role in incentivising these outcomes. For instance, SFCs can recommend tax slabs (bands) for local taxes, within which each panchayat can set its rates. As each new SFC recommends tax bands, GPs will be required to calibrate their tax rates every five years. This will ensure viable tax rate regimes with periodic resets. Further, state governments can insist that citizens produce tax and fee payment receipts for the last three years to access state-level schemes. This will not only incentivise citizens to pay local levies, it will also ensure that they demand more accountability from GPs.

Accessing Commercial Debt

While many State government Acts empower GPs to access loans for public infrastructure and service delivery, GPs have not borrowed from financial institutions. Access to debt capital markets can be a valuable source of financing for GPs, providing them the scope for planned infrastructure development.

In the absence of debt, GPs are forced to use current revenues for current needs and unable to plan effectively for the long-term. Incorporating debt in funding mix enables GPs to plan for long-term needs, borrow upfront to invest for these planned needs and repay overtime on the basis of a predictable, regular revenue stream.

The inability of GPs to ensure predictable, regular stream of revenues prevents financial institutions from providing debt finance to them. Unless this fundamental credit risk issue is resolved by GPs, debt financing will remain unviable, irrespective of state governments allowing them debt access.

Apart from enhancing own revenue generation capabilities, GPs need to substantially improve their overall administrative and technical capacities to access debt, particularly long-term bonds. They will require credit rating, which has to be high investment-grade to access low-cost funds from bond issues. Ratings are determined by the quality of administration — skilled manpower, use of appropriate technology, robust processes and quality of financial management.

Considering current GP capacities, considerable improvements are required on these fronts before bond access for rural infrastructure becomes a reality. The government can play an enabling role by developing bond-bank type structures that enable pooling of projects from multiple GPs and issue bonds backed by the cash flows of these projects.

Another mechanism that can be used to finance rural infrastructure is Special Purpose Vehicles (SPVs) created by local communities. If there is an infrastructure need and the community is willing to pay for it, then the community can form an SPV that can be used to float tenders for the requisite project(s) and route funds. Overall, if the core issue of local revenue generation is addressed, a number of financing mechanisms for rural infrastructure development become feasible.

This article first appeared in The Hindu Business Line.


How markets can serve farmers

By Uday Krishna & Rajendra Kumar, Agricultural Terminal Markets Network Enterprise, IFMR Trust

Agriculture incomes in India are volatile because of a number of unforeseen factors, such as weather, disease/pest infestations and/or market conditions. With 65 per cent of the population dependent on agriculture, it is essential to manage both production and price risks. The government has responded by encouraging the setting up of modern exchanges, with daily mark-to-market margins, a trade guarantee fund, back-end computerisation, on-line trading and demutualising of new exchanges.

However, to realise the benefits from such initiatives, the bulk of farmers, who are small and marginal, require access to finance immediately after harvest, though they possess limited collateral to obtain bank funding. Physical collateral such as land and agricultural implements are of little value in mitigating a financier’s risks as the collateral is difficult to enforce and has a low resale value.

Liquidity problems

Agriculture is a seasonal business with high price uncertainty. During harvest, prices drop due to excess supply. But, if the harvest is lower than expected, the prices rise. Hedging against price fluctuation is possible through derivative contracts such as commodity futures, fixed price forward sales or purchase of put options.

With commodity futures, the farmer agrees to sell the commodity at a pre-determined price and date. While a fixed price forward sale agreement is possibly the simplest price hedging strategy, it is difficult to find the right counter-party unless the size of the expected crop is reasonably well known, prices are satisfactory and buyers have enough confidence in the seller to commit on a forward basis.

Since there are several variables, such contracts are better implemented with a put option for the farmer or a call option for the buyer. In India, proposals to allow options in commodities and provide for registration of brokers by suitably amending the Forward Contracts (Regulation) Act have been pending in Parliament for over five years.

Warehouse receipt financing

Small farmers need liquidity urgently and the crop is inevitably sold to traders/village-level aggregators immediately after harvest. The buyers hold the stock through the harvest season till prices rise. If farmers are enabled to hold their crop beyond harvest, this price benefit could accrue to them. Farmers face two major problems — lumpy cash flows and non-availability of intermediate finance.

Warehouse receipt finance, which can be used to extend the sales period beyond harvest season and secure collateral for obtaining finance, can play an important role in smoothening farmers’ incomes by providing liquidity at times when cash-flows dry out.

The concept of warehouse receipt financing is not new in India. Banks have been extending these facilities to large aggregators, traders and bulk farmers, ignoring small and marginal farmers. Extending cheaper credit to small/marginal farmers is easily done through warehouse receipt financing if banks purchase suitable hedges on the price of commodities, assuming only a minimal credit risk.

In warehouse receipts financing, producers deposit goods of a certain quality, quantity and grade in accredited warehouses and receive a receipt for it. Since these receipts are now accepted as negotiable instruments (under the Warehouse Development and Regulation Act 2007), they can be traded, sold, swapped and used as collateral to support borrowing or accepted for delivery against a derivative instrument such as futures contract. This facilitates access to finance.

For the receipts to work effectively, it is essential to ensure infrastructure, and grading and collateral management systems which guarantee the quality and quantity of stored commodities. This will provide comfort to farmers — to store their produce, as well as to banks — to accept warehouse receipts as secure collateral to finance farmers.

Trading units on national-level commodity exchanges are large, preventing small and marginal farmers from participating individually; they depend on local mandis/middlemen. Also, the rather small number of delivery centres and the price difference across physical markets limit farmers from participating in trading.

There is a need to increase the reach, provide the services of an assayer and reduce transportation costs. Setting up local access to commodity exchanges and end-buyers, allowing them the kind of price discovery offered by national exchanges, and convenience of access, is a possible solution.

An example of a local exchange is the Agricultural Terminal Markets Network Enterprise, which works with castor farmers, allowing them to trade at local branches across Kadi Taluka, 65 km from Ahmedabad.

Price discovery

Small and marginal farmers are also inconvenienced by the inter-bank settlement time, preventing exchanges from making instantaneous payments to traders. Price discovery between international and domestic commodity markets can improve by allowing banks to offer commodity solutions as an intermediary between international counterparties and smaller Indian companies.

While domestic exchanges currently offer over 50 commodities across various segments, the number of contracts listed on the exchange for agricultural commodities continues to be low. As the number of listed contracts increases, price discovery will improve.

This article first appeared in The Hindu Business Line.