By Pallav Srivastava

What is financial inclusion? Simply put, it is the provision of equal availability of opportunities to financial services such as a bank account and credit. Why is it important? The key economic concept of growth can only be achieved when everyone in a country (not just the rich) has access to these financial resources. These ‘resources’ are as basic as having a bank account to conduct transactions. These resources are scarce in developing economies. As compared to developed countries (94% of adults have a bank account), developing countries (50% of adults have a bank account. This number drops to less than 15% in some states) are lagging far behind.

The reasons behind this lag are manifold, but central banks today focus on solving this problem by pushing for more and more financial inclusion by individual banks. How are banks expected to contribute to financial inclusion? One technique is by mandating institutions to reach out to the underprivileged and the excluded. However, often this is unprofitable for financial institutions.

Let us first look at the benefits generated from financial inclusion, and we will then move to why banks find the approach unprofitable.

Foremost are the social benefits. When a manual laborer on a farm is provided access to credit, he/she may be able to initiate a small business, such as sewing or poultry. He/she will then be able to contribute to the family income as well as earn more on average, thus climbing a rung in the social status ladder. He/she will also be better insulated from the whims of an employer as well as natural events that would earlier have threatened his/her low-paid employment on a farm.

Then we have infrastructural benefits. If a large section of the populace is endowed with bank accounts and sufficient opportunities to use these bank accounts (increased payment digitization, for example), it will lead to the reduction of cash in the economy and lower inefficiency for banks (Ardizzi et al., 2018). The government can directly transfer benefits to these bank accounts as well. Furthermore, if more and more people are included in this digitization expansion, it will enhance banks’ reserve management performance (i.e., reducing opportunity and penalty costs) by providing more timely information on deposits and withdrawals affecting the banks’ reserve accounts.

Why do banks hesitate to participate in this financial inclusion drive? Much of the time, it is simply not profitable for the bank. Firstly, it is difficult for the banker to quantify the social benefits created by the sewing enterprise; to him/her, it is merely an externality, and he/she cannot monetize the benefit. To them, it is a choice between lending to a low-collateral high-risk villager or not. It is a choice on whether to spend a considerable chunk of money by going to remote areas and setting up ATMs and bank accounts with no tangible benefits in sight. However, a central planner, whether the government or the central bank, can look at the broader picture, decide the benefits, and initiate a mandate for the banks to follow. Even when these mandates are imposed, bankers can simply choose to manipulate their implementation of the mandate. They can simply target low-risk, high-access projects even in the mandated category. Further, they can misrepresent ordinary activity so that it falls into the eligible list as per the mandate. Public sector banks, already plagued by competition (which reduces their profitability), find it challenging to implement the mandate, and continue to earn enough to stay afloat.

What is the solution? Well, often, central planners (governments/central banks) share some of the costs faced by banks. They do this by offering subsidies to set up bank accounts, ATMs, branches, etc. in remote areas, thus incentivizing banks to participate in the inclusion drives. This is one way of doing so. According to Raghuram Rajan, it can be done with “narrow targeting of mandates to the truly excluded and explicit payment for fulfilling the mandate (so that they are delivered by the most efficient) should be the norm.”