Inclusive Financial Systems

Some Design Principles and a Case Study

Besides facilitating overall economic growth, finance can help individuals smooth their
income, insure themselves against risks and broaden investment opportunities. Empirical
evidence shows that inclusive financial systems significantly raise growth, alleviate poverty
and expand economic opportunity. This paper lays out several principles that should be kept
in mind when designing such systems, supported by a case study of ICICI Bank.
NACHIKET MOR, BINDU ANANTH

F
inancial inclusion, at a minimum, may be interpreted to The distribution/origination function may be viewed as sepa-
mean the ability of every individual to access basic financial rable from the function of providing risk capital and owning the
services which include savings, loans and insurance in a financial asset/claim (whether it is a loan, savings or insurance
manner that is reasonably convenient and flexible in terms of product). This is related to the previous point. Organisations
access and design and reliable in the sense that the savings are most capable of managing risk through diversification and other
safe and that insurance claims will be paid with certainty. In our strategies that imply a certain level of scale might not have
view the provision of these services requires adherence to certain expertise in origination of assets that require local information.
core design principles irrespective of whether the provider is a Similarly, large financial institutions and banks often have cost and
cooperative bank, regional rural bank, scheduled commercial control structures that make the handling of small savings ac-
bank, non-banking finance company (NBFC) or a not-for-profit civil counts and loans unduly expensive and inflexible. In these sce-
society organisation. We have outlined these principles below. narios, there is a good case for pursuing hybrid models where
the outreach of local institutions can be combined with the ability
I of larger and regulated organisations to manage risks. The re-
Design Principles for Inclusive cently developed business correspondent model3 brings this in-
Financial Systems sight to bear in offering savings services to rural India. ICICI
Bank’s partnership model in microfinance (discussed later
Financial Services Providers’ Perspective in the note) is also based on this. This may well be extended
to improving access to insurance and other financial services in
Providers of financial services must be able to fully recover under-served markets, without necessarily infusing additional
all the costs that they incur in the provision of these services. risk capital at all levels of the financial intermediation chain and
A model that relies on cross-subsidisation is inherently unstable entailing inefficient usage of an extremely scarce resource, capital.
because as soon as the source of the profit that is supposed to In the case of a provider of loans, the entity must have sufficient
cross-subsidise disappears, so does the ability to cross-subsidise capacity (either driven by an operating model, specialised knowl-
and therefore, offer this service. edge or proximity to the customer)to adequately assess credit
Risks in a lending or insurance business should be warehoused risk and subsequently collect money from the borrower.
by institutions most capable of managing these. Specifically, in While very institution must have an adequate scale, it must also
the case of institutions that seek to offer retail deposit taking and be configured in such a manner so as to be managed well and
insurance services, they must have an adequate amount of fi- have the ability to retain and build on its ability to assess local
nancial capital to protect the financiers (depositors and insurance risks and opportunities.
policyholders) of the risks that offering this service implies.1 The
reference here is to cooperative banks, regional rural banks, Client Perspective
scheduled commercial banks, deposit taking non-banking finance
companies and not-for-profit civil society organisations that are While convenience of access may be defined in various ways,
engaged in the business of deposit mobilisation – including self- providers must ensure that the point at which the financial service
help groups (SHGs) where group-leaders are permitted to collect is accessed must be no more than an hour’s walk from the place
savings and operate group savings accounts on behalf of the self- of residence of the client and must have hours of operation that
help group members thus acting as mini deposit-taking insti- allow this access to happen in a manner that is convenient to
tutions.2 The belief is that to be a reliable provider of insurance the client and does not result in a loss of wage owing to travel
and deposit taking services, the institution must be a formally to and from the access point.4 This point of transaction must be
regulated entity, have a minimum amount of capital that is such that it does not exclude people from a literacy status, gender
specified by the regulator for any entity that seeks to offer or other socio-economic considerations.
these services and an adequate amount of capital for the Comprehensiveness of access to financial services is key from
risks it assumes so as to protect its depositors and insurance a client perspective. In other words, the client must be able to
policyholders. choose from a range of services that includes basic banking,

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credit, insurance (including life, accident, health, weather) given substantive concessions, they have not delivered on the objective
his/her particular requirement. A focus on credit alone might not of financial inclusion. This experience shows us that financial
fully address the household’s risk management and consumption inclusion cannot be achieved merely by diluting design principles.
requirements. On the contrary, that may impede the emergence of other models
In the landscape of providing access to financial services to with the potential to address the challenge of financial inclusion.
poor households, two distinct but complementary models have The regulator has been concerned that lowering the entry level
emerged. One in which the managerial aspects related to such capital requirement in order to obtain banking and NBFC licences
access is the responsibility of a specialised service provider, say might lead to proliferation of entities. The concern is with ref-
a NBFC or a cooperative bank, and another in which this erence to the regulatory capacity being a limiting factor – if “too
responsibility is assumed by the users/community themselves, many” underlying regulated institutions are created, then the
as in the SHG models where groups take responsibility for supervision responsibilities on the regulator may become un-
accounting and book-keeping. Each model of financial services sustainable.6 Implicitly, the minimum capital norm is also meant
delivery has its own unique strengths; however, clients must have to be a screening device for quality of financial service providers.
a choice between the two. Policy-makers must not assume One pragmatic alternative that reconciles this trade-off between
that managerial responsibilities are easy to assume and discharge financial access and supervision load is to consider models such
or that low-income households are eager to do so in every in- as the partnership model (for credit) and business correspondent
stance. This is particularly the case for households with com- (for savings) that rely on already regulated entities extending their
peting demands for time as is the case with urban low-income outreach through third parties. Where entities desire to warehouse
households. Specialised service providers provide this manage- risk on their own balance sheet, they would have to be in conformity
rial ability in return for a fee. Clients must be free to choose to the minimum capital norms specified by the central bank.7
between paying that fee to an external provider or internalising
these managerial costs themselves through self-organisation into II
groups of various kinds. In either case, the important point is What Have We Learnt about
that these costs exist. The fact that communities internalise them ‘What Does Not Work’?
does not mean that they go unreckoned. In addition, there is also
a concern about viewing community groups as permanent entities. Attempts to impose interest rate caps have resulted in either
Even if we concede that a group can mange a savings or credit distortion of pricing by providers or withdrawal of lenders thereby
operation in perpetuity, this approach is not flexible to accom- hurting rather than aiding improving access to finance.8
modate the evolving financial service needs of the underlying
members – be it larger loan sizes, individual liability loans or Deposit-Taking by Poorly Capitalised and
new products such as insurance and derivatives. Once again the Narrowly Diversified Entities
point being made here is that the choice of format to access
financial services must be left to the customer at all points in Given the experiences of a variety of service providers on the
time and there should be no attempt in the design to hard-code ground, there would be real concern if, particularly for the poor,
a particular format in which delivery is possible. poorly capitalised entities are permitted to warehouse risk on their
Specifically in the case of credit, individuals unable to offer balance sheet. The points of failure could be multiple:
collateral must be able to systematically build and “port” their (1) Use of savings for on-lending into the same geography exposes
credit history across financial service providers. Helping the poor client savings to systemic risk in the region. This approach does
develop credit histories and centralising credit histories make not leverage benefits of national diversification to provide se-
credit markets less segmented and therefore, borrowers have curity and liquidity to client savings. This concern is applicable
access to cheapest sources of credit.5 to a wide class of service providers: (a) non-bank finance com-
panies; (b) cooperative banks; (c) regional rural banks; and
Regulator Perspective (d) SHGs that collect savings and use them for on-lending directly
or as collateral in some form. For example, people in a region
The preceding discussion seeks to make the point that the final might be saving in order to build protection against rainfall
configuration of how access to finance is created is dynamic and failures. In a model in which deposits from these individuals are
must be informed by previous experiences in this regard. The re-deployed as loans in the same geography, rainfall failure might
outcomes that regulators should care about are (a) whether access imply loan riskiness and therefore, inability of savers to use
to financial services is universal, (b) whether such access is of deposits when they need it the most.
a quality that is acceptable (here, quality is used to cover aspects (2) As a consequence of the above, narrowly operating entities
such as the lender-borrower relationship and features of financial typically have to offer higher rates of interest to attract depositors.
services offered) and (c) whether providers are sustainable and This in turn forces them to charge higher rates on loans. This
meet certain governance norms. Regulation must not favour one gives rise to the concern that the loan portfolio over time will
or the other model for reasons beyond the above, i e, regulators suffer from the problem of adverse selection – those who are
must be outcome-driven and model-neutral. Historically, certain willing to borrow at higher rates may be “riskier” thereby af-
institutional designs have been supported with a view to increasing fecting the security of depositors in the same entity.
financial inclusion. For example, cooperative banks and regional (3) An entity that accepts deposits in addition to a lending function
rural banks were created with this mandate. The primacy of this must be able to manage the inherent asset-liability management
mandate has often meant that other metrics such as capital issues and liquidity risks. This entails the ability to invest in
adequacy have not been used to evaluate these institutions and automation and information systems that can support these func-
these entities have been recapitalised on occasions. Despite these tions, which is typically not the case with small entities.

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(4) Additionally, lack of access to instruments such as credit products in rural areas. ICICI Bank takes full responsibility for
derivatives impairs the ability of these entities to manage credit its correspondent’s business conduct. The bank has already
risk through strategies other than diversification in origination. launched this service in Orissa and Andhra Pradesh.12
This in turn is challenging for entities that by design operate in (5) Similarly in insurance, ICICI Bank and its group companies
narrow geographies. ICICI Prudential Life Insurance Company and ICICI Lombard
Governments investing in creating systemic infrastructure are General Insurance Company work with local institutions for
seen to facilitate other providers to work in these markets. This design and delivery of insurance products – under the
systemic infrastructure could take the form of national identi- bancassurance model these policies will be sold at the ICICI Bank
fication numbers, credit registries, payment systems, electronic grameen kendras. Given the peculiar challenges of health insur-
commodity and auction markets and weather measurement sta- ance delivery, it has worked with hospital networks and third-
tions that are in the nature of public goods and stimulate market party administrators to coordinate quality of healthcare as well.
activity. This is superior to more “interventionist approaches” (6) In order to facilitate better price discovery and price risk
such as the government being a provider of subsidised financial management for farmers, ICICI Bank co-promoted the National
services.9 Commodity and Derivates Exchange (NCDEX) jointly with
National Bank for Agriculture and Rural Development
III (NABARD), the National Stock Exchange (NSE) and Life
ICICI Bank Case Study Insurance Corporation (LIC). NCDEX along with its affiliate
National Commodities Management Services Limited (NCMSL)
While these design principles may be consistent with many is attempting to improve access to price derivatives for farmers,
on-ground configurations pursued by other institutions, ICICI facilitate commodity-based finance through banks, provide weather
Bank has chosen the following: stations and improve the warehousing infrastructure.13
(1) ICICI Bank and its group companies are to be the providers (7) For its work in product development, ICICI Bank has com-
of deposit taking and insurance services and therefore they bined its expertise in financial engineering with the insights
warehouse all the attendant risks. Since as on June 30, 2006 its generated by its partners and allied research institutions. To date,
assets are $ 60 billion, its networth exceeds $ 5 billion ICICI Bank and its group companies have designed and are taking
and its rating is AAA, it is in a good position to absorb these to scale products including the following: (a) index-based rainfall
risks. As on date, ICICI Bank has built a portfolio exceeding insurance; (b) catastrophic health insurance; (c) working capital
Rs 16,000 crore in rural finance of which Rs 2,500 crore is to low- facilities for agriculture traders; (d) working capital facilities for
income families and has a customer base exceeding 2.5 million crafts people and artisans; (e) take-out finance for start-up local
clients. financial institutions; (f) warehouse receipt based financing;
(2) To develop a relationship with a network of local institutions (g) credit to low-income households through the partnership
(both urban and rural), which could be cooperative banks, pro- model; and (h) savings to low income households through banking
ducer cooperatives, NBFCs and not-for-profit civil society correspondent model.
organisations to actually distribute these services. A combination (8) It is ICICI Bank’s belief that in order to improve efficiencies
of these partner institutions, rural hub branches at a cluster level in financial intermediation, especially in the context of small
and agents (such as tractor dealers) appointed by the bank rep- unsecured loans, the role of technology is crucial. ICICI Bank’s
resent the core of its “no white spaces” strategy that aims to cover initiatives in technology may be broadly thought of in two
200 districts by 2007. Under this strategy, the bank plans to have categories: (1) Front-end technology investments – this includes
at least one touch point (collectively referred to as ICICI Bank issuance of smart cards with unique identifiers to its clients that
‘grameen kendras’ which may belong to ICICI Bank or its help the client track financial services usage data on a real-time
partners) every three to five kilometres in rural and semi-urban basis as well as sharing of credit information across ICICI Bank’s
areas [Iyer 2006]. If the model succeeds this implies that the network. (2) Back-end technology investments – this relates to
number of ICICI Bank grameen kendras capable of offering a investment in creating better core banking systems among its
reasonably complete suite of financial services would exceed partner institutions. This enables more efficient data capture and
50,000 (or 1 for every 10 to 12 villages) by March 2007 and the sharing and reduces margin of error on transactions. ICICI Bank
customer base could exceed 25 million by 2010 [Anand 2006]. has collaborated with FINO, a company that seeks to provide
(3) To use the “partnership model” for the lending business in front-end (smart card, point-of-sale terminals), back-end (banking
order to build incentive compatibility with the local institution software, performance management and reporting, MIS) and
that is delivering this specific financial service. This design draws information services (credit bureau) to community-based financial
on the separation of functions discussion in the preceding section. institutions14 and is now looking to partner with NABARD, State
The partnership model leverages the local information and cost Bank of India and the Credit Information Bureau of India Limited
structure of a local financial institution in order to unlock the to try and see if FINO could, as in the case of NCDEX, become
financing ability latent in the commercial banking sector. The a provider of these technology services on a system-wide basis
model has been designed with the feature of the local institution particularly to cooperative banks and NBFCs engaged in the
sharing the risk with the bank so that there is careful origination business of lending to and collecting savings from small borro-
and supervision on an ongoing basis.10 wers. The participation of the RBI and NABARD in some of
(4) For deposit taking work with a variety of local institutions these initiatives that have a systemic benefit would be an accele-
to provide these services under the business correspondent rator of access to finance.
model.11 Business correspondents are agents identified by the (9) ICICI Bank is conscious that working in rural India and with
bank to provide basic banking services such as opening bank poor households is fairly uncharted territory. It has tried to base
accounts, collecting savings and deposits and offering insurance its growth strategies on systematic results of what works at the

Economic and Political Weekly March 31, 2007 1125

household and local economy levels. In order to catalyse high- 4 Morduch and Rutherford (2003) defines the important dimensions of
quality work in this area, it works closely with research centres access as being (a) reliability – whether finance is available when needed
that systematically research issues related to access to finance.15 or desired, (b) convenience – how easy it is to access finance, (c) continuity
– ability to access finance repeatedly, and (d) flexibility – whether the
These centres are housed within the Institute for Financial Manage- product is tailored to the needs of the household or enterprise.
ment and Research and they seek to provide thought leadership 5 See Banerjee (2001). Similarly, Rajan and Zingales (2003) also emphasise
to all institutions working in this field. the role of initiatives such as credit bureaus expanding access to finance,
especially for those who cannot afford to provide collateral.
6 How many regulated institutions is “too many” is an issue to be debated
IV and understood.
Conclusions 7 What this minimum level of capital must be would be derived from the
desired scale of investment in systems and processes as well as the
This paper aims to express a point of view on the financial minimum level of asset diversification that needs to be built in order for
system design principles essential to achieve the goal of financial the deposits to have an investment grade rating and to deal with liquidity
inclusion. A shared vision of what these financial system design shocks that may occur from time to time. Answers to both the above can
be found through debate and research. In the case of banks, Rs 25 crore
principles are, can guide thinking on what the key initiatives (in
might be an appropriate minimum capital requirement.
order of priority) are for achieving inclusion. While the principles 8 See Helms and Reille (2004) and Porteous (2006). The latter discusses
outlined in this note including capital adequacy, cost recovery the experiences of Uganda, Bangladesh and Bolivia with respect to
and institutional pre-requisites of entities warehousing risk may competition and interest rates.
not be complete or accurate, it is certainly our belief that these 9 See Demirguc-Kunt (2006) for a discussion on the role of the government
or variants of these principles must first be agreed upon before in financial sector development.
any attempt is made to implement a particular design or reform. 10 See Ananth (2005), Harper (2006) and Report of the Internal Group to
Examine Issues Relating to Rural Credit and Microfinance (2005) for
Many of the achievements of institutions in rural and micro- a detailed discussion on ICICI Bank’s partnership model.
finance are in the nature of “second best” owing to the fact that 11 RBI circular RBI/2005-06/331 DBOD.No.BL.BC.72/22.01.009/2005-
there are deeper structural constraints that have not been recognised 2006.
or past failures that have not been learnt from. Current prescrip- 12 See ‘ICICI Bank to Hire More Banking Correspondents’, The Hindu
tions for reform that are being implemented or debated do not Business Line, August, 2, 2006.
recognise this and instead, address symptomatic issues. For 13 ICICI Bank is also working closely with SAFAL in Bangalore to attempt
a similar transformation in the processes for fruits and vegetables.
example, the inability to track credit information or effectively 14 See ‘ICICI Bank Launches New Initiative in Microfinance’, The Hindu
recover collateral poses challenges to every lender in the financial Business Line, July 14, 2006.
system, forces distortion in product design and may even prevent 15 This includes the centre for microfinance, centre for development finance,
entry of lenders. The note discusses the salient design aspects centre for insurance and risk management and the centre for small
from the perspective of the provider, client and regulator. It also enterprise finance. More details on them may be obtainable from the IFMR
discusses some lessons from past experience such as allowing web-site: www.ifmr.ac.in.
deposit-taking by poorly capitalised entities, all with a focus on
design considerations. While designing a financial system to References
maximise access to the poor, rather than dilute basic design Anand, A (2006): ‘ICICI Bank’s Rural Thrust’, Business Today, June 4,
principles that are key to sustainability, these should be adhered pp 84-88.
to even more rigorously. The ICICI Bank case study is discussed Ananth, B (2005): ‘Financing Microfinance: ICICI Bank’s Partnership Model’,
as a specific configuration consistent with these principles and Small Enterprise Development Journal, Vol 16, No 1.
Banerjee, A (2001): ‘Contracting Constraints, Credit Markets and Economic
designed for maximising financial inclusion. EPW
Development’, MIT Working Paper Series, pp 02-17.
Demirguc-Kunt, (2006): ‘Finance and Economic Development: Policy Choices
Email: nachiket.mor@icicibank.com for Developing Countries’, World Bank Policy Research Working Paper
bindu_ananth@ksg07.harvard.edu No 3955.
Helms, B, X Reille (2004): ‘Interest Rate Ceilings and Microfinance: The
Story So Far’, CGAP Occasional Paper No 9, www.cgap.org.
Notes Iyer, P (2006): ‘ICICI Bank to Cover 60 Districts by Year-End’, Business
[The views expressed in this note are entirely those of the authors and do Standard, March 16.
not in any way reflect the views of the institutions with which they are International Network of Alternative Financial Institutions Report on
associated.] ‘Contemporary Issues in Regulation of Microfinance Sector’, unpublished
document.
1 This capital adequacy framework, now guided by the internal ratings ‘ICICI Bank Launches New Initiative in Microfinance’, The Hindu Business
approach of Basle II, must apply in a stringent, institutional neutral manner Line, July 14, 2006.
particularly for those institutions that choose to warehouse these risks ‘ICICI Bank to Hire More Banking Correspondents’, The Hindu Business
on their balance sheet and finance themselves by accessing retail deposits Line, August, 2, 2006.
or offering insurance services. Morduch, J and S Rutherford (2003): ‘Microfinance: Analytical Issues for
2 Certain self-help promoting organisations are interpreting savings in an India’, Essay for the World Bank, South Asia Region – Finance and Private
SHG as member equity. However, this immediately endows it a character Sector Development, April 2003.
different from the safety and liquidity associated with savings. See for Porteous, David (2006): ‘Competition and Microcredit Interest Rates’, CGAP
instance the INAFI report (2006) that says, “The savings of the poor within Focus Note No 33, www.cgap.org.
their group build their stake and ownership which means savings is not Rajan, R G and L Zingales (2003): Saving Capitalism from the Capitalists,
a product but has a strong character of equity and effectively used for Crown Publishing.
leveraging further resource mobilisation and also as a hedge against risk”. RBI circular RBI/2005-06/331 DBOD.No.BL.BC.72/22.01.009/2005-2006,
3 See RBI circular RBI/2005-06/331 DBOD.No.BL.BC.72/22.01.009/2005- www.rbi.org.in.
2006 and the Report of the Internal Group to Examine Issues Relating The report of the internal group to examine issues relating to rural credit
to Rural Credit and Microfinance, July 2005, www.rbi.org.in and microfinance, July 2005, www.rbi.org.in.

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