By Parush Arora, Sonal Barve, Megha Saran & Devanshi Gupta | State level Winners RBI Policy Challenge 2017
Introduction
A new wave of technological innovations in the financial sector has brought about a
colossal change in the traditional financial system. Such innovations known as FinTech, coming from the technology start-ups, are altering sectors like mobile payments, money transfers, loans, fundraising and even asset management. A very broad word though can be summarized within four categories namely electronic currencies, the digital payment platform, online finance and investment platforms and data analytics. FinTech is largely expected to bring in a new breed of disruptors that will displace traditional financial market with more efficient one given its implementation doesn’t weaken security, monetary policy transmission and financial
stability.
FinTech in Developed Nations
Developed countries all over are characterized by open and sophisticated financial markets. Their FinTech sector receives government support through less regulations, grants and tax incentives. For instance, the Monetary Authority of Singapore established a dedicated FinTech office with funding from various government entities to promote development and growth of Singapore as a FinTech hub. Some examples are given below.
• Peer-to-peer lending companies like Lending Club in the US and Funding Circle in the UK have typically low on-going expenses on their outstanding loan balances as compared to conventional lenders.
• Financial disruptors in these countries have also developed shrewd new ways of gauging risk. In the US, small business lending companies such as Kabbage and OnDeck take up information, on everything from social-media reviews to companies’ usage of logistics firms, to evaluate how well small businesses are doing.
• Banks take in short-term liabilities such as deposits and turn them into long- term assets such as mortgages. As a result, they have a tendency to mismatch their balance sheets by possessing more assets than liabilities for medium- and long-term obligations. FinTech firms such as Prosper in the US and Zopa in the UK are helping avoid this basic risk of mismatched maturities inherent in banking by matching borrowers and savers directly.
One reason for the availability of smooth market conditions and large incentives to
FinTech firms is the presence of strong, well defined and credible financial institutions which developing countries lack. These institutions act as a facilitator whose main objective is to keep the market fully efficient.
Current Indian Scenario- Need for FinTech
There are over 32,000 branches of rural commercial bank and Regional Rural banks,
around 14,000 cooperative bank branches, over 95000 Primary Agricultural Credit Societies (PACS) with 154,000 outlets that facilitate money transfers and deposit mobilization. Still, the current financial infrastructure aiding access to finance is inadequate given the demand in the economy. With around 64% of the total population living in rural areas, 70% of the rural poor do not have a bank account and 87% have no access to credit from a formal source. As of June 2017, India has 222,762 ATMs all over the country, i.e. only about 18 ATMs per 100,000 adults.
Reasons for Inadequate Access to Finance to the Rural Poor
i. Supply Side
The formal credit market is hesitant to approach the rural poor because of the borrower’s lack of collateral, high transaction costs arising due to small loan sizes, high frequency of transactions and widespread illiteracy which make serving the rural poor a risky and costly proposition for banks. Moreover, the absence of credit information further like repayment capacity raises default of risk. Another key task for banks to reduce the level of NPAs before financial inclusion can be implemented in a sustainable way.
ii. Demand Side
On the other hand, rural people could not find flexible products offered by financial firms that meet their income and expenditure patterns. Borrowers face high transaction costs, cumbersome procedures for opening an account and seeking loans, and often have to pay hefty bribes because of high chances of rejection. This high eventual cost further drives them away from the formal banking sector. Their access to financial services is also limited by psychological and cultural barriers and in some cases, lack of legal identity.
Approach to Improve Access to Finance
In the past, several initiatives such as the SHG-Bank Linkage Program, establishment of Microfinance Institutions, emerging partnerships between private banks, microfinanciers, and service providers as well as schemes like the Kisan Credit Card have so far shown varying degrees of success.
The excluded population needs efficiency, innovation and value for money. This can be provided by motivated financiers who have low cost structures and find it profitable to serve poor and small borrowers. This serves as a very good opportunity for FinTech platforms to reach out to people across such geographical areas and income groups where traditional banking services have failed to make an impact.
Potential for FinTech Growth in India
The year 2015 saw the emergence of numerous Indian FinTech start-ups, incubators and investments from public and private investors. There are several factors that are
in favour of the on-going FinTech revolution –
• India has a robust tech ecosystem based on world-leading software and information technology and is also now the second largest smartphone market. Mobile 3G/4G services and better-quality smartphones are spurring internet usage.
• In 2009, India launched the Aadhaar ID scheme, providing a digital identity to over one billion Indians. The National Payments Corporation of India (NPCI) launched the Aadhaar Payments Bridge and Aadhaar Enabled Payments System in 2011, which uses the Aadhaar ID as a principal key for electronically routing government benefits and subsidies.
• In August 2015, the RBI licensed new categories of financial institution, payment banks and small finance banks, to further reach out to the millions that are still unbanked and are without access to basic banking services.
• Fintech Valley, Vizag is an initiative of the Government of Andhra Pradesh, launched in December 2016 to promote business infrastructure in the state, and to build into a thriving Finance & Technology ecosystem.
• Bharat Interface for Money (BHIM), launched by NPCI in December 2016, is a UPI based digital payments platform providing access to banking and digital payments to both smartphone and non-smartphone users.
• Lending in India is largely limited to banks. Upcoming P2P lending start-ups are changing this mix by democratizing lending. So, anyone with disposable income can become potential lender.
• Post demonetization, the cash-deprived economy also saw a rise in blockchain technology and bitcoin start-ups like ZebPay, Unocoin, etc. are now offering opportunities for crypto currency investments.
Challenges to FinTech growth in India
Data security includes threat of hacking, identity theft and extortion attacks. Since the internet is a public network with unrestricted access, security risk also arises from unauthorized access to banks’ critical information stores like accounting system, risk management system, portfolio management system, etc. A breach of security could result in direct financial loss to the bank.
Legal risk stems from the violation of prescribed laws, rules, regulations or when the legal rights and obligations of parties to a transaction are not well established. Given the relatively new nature of FinTech banking, rights and obligations in some cases are uncertain and applicability of laws and rules is uncertain or ambiguous. Apart from that, India does not have a privacy law.
Poor financial institutions - The financial system is unsophisticated and rudimentary
due to tight regulation which limits the development and introduction of new financial products. Strong institutions are needed for effective regulations that safeguards financial innovation.
FinTech & Access to Finance – An Econometric Analysis
The monthly data is Imported from CMIE Prowess and RBI website from October 2015 to September 2017.
Access to Finance Variable
The Access to Finance variable is calculated using several other variables namely: -
1) Total number of ATMs on-site and off site
2) Total number of POS online and offline
3) Total number of outstanding credit and debit cards
4) Total number of beneficiaries in banks
An index is developed using the above-mentioned variables through dynamic factor
analysis and the latent variable of Access to Finance is calculated which follows an AR (1) process. Coefficients of all the variables came out to be significant at 10% level. We rejected models where likelihood did not converge even after 1000 iterations.
FinTech variable
The FinTech variable is proxied using the average growth rate in the total factor productivity of 10,130 financial companies of India. A trans log production function (KLEM) is used with inputs such as labour (number of employees), capital (net fixed assets), energy (power) and raw materials. We used net sales as total output.
Y=Aƒ(K,L,E,M)
Here “A” is the technological factor denoting total factor productivity. Analysis of total
factor productivity (TFP) measures the increase in total output which is not accounted for by increases in total inputs. All the static variables were converted into growth rates by taking the log difference of each. The TFP growth rate is calculated for the concerned period by estimating the production function using fixed effect model and predicting the residuals. The TFP growth rate is used as a proxy for growth in FinTech.
Vector Auto Regression Model
We have tried to capture the relationship between FinTech and Access to Finance
using a Vector Auto regression (VAR) model. We took FinTech and Access to Finance as our endogenous variables and GDP per capita, Inflation and Demonetization dummy as the exogenous variables. The number of lags considered were 3 using Akaike Information Criterion (AIC). Demonetization dummy takes a value 1 for November 2016 and 0 otherwise. We considered demonetization as a one-off shock whose impact slowly faded post November 2016. The identification restriction is applied using Cholesky Decomposition where higher order is assigned to FinTech Variable. The hypothesis here is that FinTech has a contemporaneous affect on Access to finance and Access to Finance has a lag affect through increase in demand for FinTech.
Looking at the graph, one can infer that a positive shock in FinTech leads to a positive movement in the variables aiding Access to Finance. The result is significant at 95% confidence interval for the first two steps (months). The Granger causality test confirms that FinTech granger causes changes in variables representing Access to Finance at 10% level of significance. After controlling for the effects of growth, inflation and demonetisation we found that growth in Fin Tech would have a statistically significant effect on the growth in Access to Finance variables. This result is preliminary evidence, and must be augmented by further studies.
Policy Recommendations
Indian regulations often allow our judiciary to intervene and modify the terms of a loan, and even forgive obligations. For instance, while banking companies are exempted from the Usurious Loans Act of 1918, P2P lending platforms, which often have higher rates due to unsecured debt, are not. As a result, a borrower accessing credit from such platforms might seek judicial intervention in his or her repayment obligations causing investments to be stuck in dispute. Thus, such platforms need their own local laws of compliance.
• Government needs to assist start-ups with an effective policy such as easy business set-up processes and special work visa for foreign start-up entrepreneurs and technology experts.
• Just like a Monetary Policy Committee, a Financial Policy Committee can be set up to identify, monitor and act to remove systematic risk in the Indian financial system. The Bank of England set up one in the year 2010.
• A trade body directed towards FinTech needs to be set up to create a formal sector of entrepreneurs and investors. It should incentivise them towards excluded populations and enhance capital access at the seed stage for FinTech start-ups. It must also arrange for a foreign currency liability to permit cross-border transactions as the Indian rupee is not freely convertible into other currencies without regulations.
• Introduction of incentives based programs to setup agents who educate people on digital financial literacy; educational system of the country and academic institutions must work towards building an innovative mind-set of technological advancement from the very beginning.
• India’s fragmented FinTech makes the growth of the sector challenging. It must work towards establishing sophisticated FinTech hubs in the country that use FinTech to drive entrepreneurship and financial inclusion within their states.
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